What’s it: A contractionary monetary policy is a monetary policy aimed at reducing the money supply’s growth rate in the economy. Its aim is to reduce the pressure caused by high inflation and to cool the economy. High inflation can lead to hyperinflation if it is not controlled.
Monetary policy works through aggregate demand. If the contractionary policy is effective, it weakens aggregate demand in the economy. Inflation moves at a lower rate. As demand weakens, producers also moderate the pace of their production, leading to slower economic growth.
However, if policies are unsuccessful, contractionary policies can lead to economic contraction. That is undesirable and may happen when the central bank or monetary authority takes an overly aggressive approach.
To carry out a contractionary policy, the central bank has several options. Three common monetary instruments are raising the policy rate, open market operations by selling government debt securities and increasing the reserve requirement ratio.
Contractionary monetary policy is a contrast to expansionary monetary policy. The latter works in reverse, namely encouraging economic growth and inflation. Central banks adopt it during an economic contraction or recession. The monetary instrument remains the same, only in the opposite direction.
Synonym for contractionary monetary policy is a tight monetary policy or restrictive monetary policy.
When will the central bank implement a contractionary monetary policy?
The contractionary policy usually takes place during the boom phase of the economy. It is the latter part of the economic expansion. Upward inflationary pressure increases, overheating the economy. And, if uncontrolled, it can lead to hyperinflation.
In a macroeconomic equilibrium, the situation occurs when the short-run equilibrium is to the right of long-run aggregate supply (potential GDP). Aggregate demand exceeds aggregate supply, causing the price level in the economy to surge. Also, to cover excess aggregate demand, the economy increases supply from imports.
High inflationary pressure can lead to an uncontrollable direction. To avoid overheating the economy, the central bank will adopt a contractionary monetary policy.
Contractive monetary policy pushes down aggregate demand. In this case, the central bank reduces the growth rate of the money supply in the economy. As the money supply slows down, interest rates go up. Households should reduce the demand for goods and services, especially those financed through loans such as houses and cars. Likewise, businesses reduce investment because capital costs are more expensive, and demand for goods and services weakens.
In general, to guard the economy, the central bank usually sets a target for the inflation rate. They consider that at this target level, the economy is in a healthy condition. So, when the percentage has gone off target, they will intervene in the economy through several monetary policy instruments.
Difference between the expansionary monetary policy and the contractionary monetary policy
Expansionary monetary policy is the opposite of contractionary monetary policy. Under the expansionary policy, the central bank expands the money supply. The aim is to encourage economic growth by stimulating aggregate demand.
An increase in aggregate demand will slowly push up the price level in the economy. Thus, the inflation rate will rise.
Both the expansionary and contractionary policies use the same instruments. Three common instruments are the policy interest rate, open market operations, and the reserve requirement ratio.
Central banks adopt expansionary policies during weak growth, such as during recessions. Meanwhile, the adoption of contractionary policies is during an overheated economy, usually at the end of the expansion stage before the peak.
How contractionary monetary policy works
Through changes in the money supply, monetary policy works, and affects the economy. The main monetary policy tools are the benchmark interest rate, open market operations, and reserve requirement.
Contractionary monetary policy uses one or a combination of the following:
- Raising the policy rate
- Selling government securities through open market operations
- Increasing the reserve requirement ratio
The policy rate, or benchmark interest rate, is the central bank’s interest rate for short-term borrowings. It has become the primary monetary policy tool at several central banks. In Indonesia, the benchmark interest rate is the BI 7-Day Reverse Repo Rate. In the United States, it is the Fed Fund Rate (FFR).
Commercial banks usually take out short-term loans from central banks to meet short-term liquidity shortages. As a consequence, the central bank charges short-term interest rates.
The central bank lifts short-term interest rates to reduce the money supply. That increases the cost of borrowing by commercial banks. They have to spend more money to pay back the loan.
Furthermore, an increase in borrowing costs reduces commercial bank profits. That prompted commercial banks to pass on these cost increases to loan interest rates to maintain profit margins. Households and businesses earn higher interest when they apply for loans.
The increase in lending prompted households to delay purchasing durable items such as homes and cars. They usually rely on bank loans to buy these items. Long story short, when loans become more expensive, households consume less of some goods and services.
For businesses, rising interest rates make capital investment costs more expensive. It decreases investment viability because it makes it less profitable. Also, the prospect of weaker demand increases their profit pressure. As a result, they put off investing.
So, in the end, an increase in interest rates weakens consumption and investment in the economy. It slows down aggregate demand growth, forcing businesses to rationalize their output.
Open market operations
The central bank runs open market operations by buying and selling securities. In this case, the central bank’s partners are commercial banks.
When implementing a contractionary policy, the central bank will sell government securities to commercial banks. Money moves from commercial banks to central banks. Meanwhile, commercial banks now hold securities.
As a result, commercial banks have less money to lend. Their liquidity diminishes and encourages interest rates to rise.
Commercial banks set aside a portion of deposits as reserves. They must have a minimum reserve requirement, either kept at the central bank or in their own vaults.
For example, the mandatory reserve ratio is around 10%. That means commercial banks have to keep $10 out of every $100 deposit as reserves. The rest, $90, they can lend to businesses or households.
If the central bank raises the ratio to, for example, 15%, the commercial bank has less money to lend. They can only lend out 85 for every $100 deposit.
Thus, an increase in reserves reduces the money supply in the economy. Bank liquidity declines, prompting interest rates to rise.
Effects of contractionary monetary policy
The contractionary monetary policy has a broad impact on the economy. It affects inflation, economic growth, and unemployment.
When the money supply’s growth rate is slower, liquidity in financial markets becomes tighter. People becomes more challenged to find the money. Therefore, interest rates will rise because supply is more limited. For this reason, we call contractionary monetary policy tighter monetary policy because the money supply is tighter than before.
The increase in interest rates makes loans more expensive. It ultimately influences aggregate demand through its effect on the consumption and investing behavior of the private sector.
Slower economic growth
Contractionary monetary policy dampens the rate of growth in aggregate demand. Weaker demand reduces upward pressure on the price level (inflation). Also, businesses respond by reducing production rates. As a result, economic growth and inflation slow down.
The weakened aggregate demand occurs because households reduce some consumption of goods and services. At the same time, businesses are also reducing capital investment, taking into account the higher cost of capital and weaker demand.
Slower growth in the amount of money tightens liquidity and leads to higher interest rates in financial markets. Borrowing costs are more expensive, encouraging households and businesses to be reluctant to apply for new loans.
More moderate inflation rate
Slower aggregate demand reduces the rate of inflation, particularly demand-pull inflation—more or less the concept as in the law of microeconomic demand-supply (although more complex). Assuming supply is constant, a decrease in demand will create an excess supply, which will push prices down. Thus, when aggregate demand weakens, the price level (inflation) tends to fall.
Central banks usually use the inflation target as an anchor for monetary policy. If the inflation rate exceeds the target, it is time for the central bank to adopt a contractionary policy.
Weakening aggregate demand encourages businesses to rationalize production. Otherwise, it will only produce excess supply in the economy, pushing prices down even further. And, if they don’t reduce the rate of production, their profits will fall even further.
Initially, businesses will respond to weakening aggregate demand by stopping the hiring of new workers. In this situation, the unemployment rate will probably remain low.
However, if aggregate demand continues to weaken, they will respond by reducing production. Companies seek to operate more efficiently by reducing some of the operating costs. One option is to reduce labor. As a result, the unemployment rate is slowly rising.