Contractionary Monetary Policy: What is it and How Does it Work

Contractionary monetary policy is a type of monetary policy that the Federal Reserve implements when inflation threatens the economy. For example, when the economy faces an inflationary gap where the short-run aggregate demand curve intersects with the long-run aggregate supply curve, the Fed will pursue contractionary monetary policy.

This type of monetary policy is intended to prevent inflation from reaching an overheated level. Higher prices erode the standard of living of consumers. Contractionary monetary policy can be effective in preventing inflation, but economists debate whether it’s the best solution for slowing the economy. It can also increase the unemployment rate.

When is it implemented? The first time the Federal Reserve implemented contractionary monetary policy was in the late 1970s. Inflation was at a high of 6.7%, and the Federal Reserve responded by lowering rates and purchasing bonds. It was not immediately clear why, but this policy helped curb the inflationary spiral. The inflation rate dropped to 3.8% in 1982 after the Federal Reserve increased interest rates.

Contractionary monetary policy is used when real GDP falls below a target level. In this case, it has a significant impact on the real GDP and affects the interest rate and price level. The Fed’s monetary policy is a mix of expansionary and contractionary actions, which affect real GDP and price levels.

Contractionary monetary policy aims to reduce the money supply. Higher interest rates discourage consumers and businesses from spending, slowing economic growth and reducing investment. As a result, businesses reduce output, which limits the overall demand for goods and services. This leads to lower employment and lower aggregate demand.

Contractionary monetary policy is an important tool used by central bankers to bring inflation back to target. This is sometimes used when inflation expectations are high and the economy is slow. In other words, contractionary monetary policy is used by the Fed to reduce inflation expectations and move the economy toward maximum employment.

The Federal Reserve sets the policy rate through the Federal Open Market Committee. The target rate is the interest rate that banks charge each other overnight. This interest rate influences other interest rates throughout the economy. Another tool is the interest rate on reserve balances (IORB).