What is Contractionary Monetary Policy?

Contractionary Monetary Policy is when the total supply of money in the economy is reduced and interest rates are raised to combat monetary policy inflation.

• It is a macroeconomic tool which is designed to combat monetary policy inflation which results from an expanding money supply in the economy, unreasonable asset valuation and unsustainable speculation in the Stock Market.
• Initially a contractionary monetary policy result in tightening of credit in the economy, increase unemployment, reduced borrowing by private sector and reduced consumer spending resulting in overall reduction in nominal gross domestic product (GDP), however the goal is not to slow down economic growth but to make it more sustainable economic growth and smoother business cycle over the medium to long-term period.

Contractionary Monetary Policy in Detail

Let’s understand Contractionary Monetary Policy in detail.

Monetary Authorities measure an economy’s long-term sustainable real growth rate also called Real Trend rate. This Real Trend rate is difficult to observe directly and is required to be estimated. Further, the trend rate also changes over time as the structural condition of the economy changes and such structural changes in the economy reduce the trend growth rate of the economy. (Structural condition refers to changes in the saving and investment pattern in an economy, for instance, consumer shift from the use of heavy debt to increase saving and reduction in consumption).

Neutral Interest Rate=Real Trend Rate+ Inflation Target

Where Neutral Interest Rate is the growth rate of the money supply that neither increases nor decreases the economic growth rate.

When the policy rate is above the neutral interest rate, the monetary policy is said to be Contractionary Monetary Policy. By setting the policy rate above the neutral interest rate, the growth rate of the money supply is decreased. Central Bank influences interest rates by expanding or contraction of the monetary base, which is the currency in circulation and banks’ reserves (CRR and SLR) on deposits at the central bank.

Contractionary Monetary Policy Tools

These are the three main tools that are used by Central Bank to implement the Contractionary Monetary Policy:

• Open Market Operations: Buying and selling of government securities by the central bank (in the case of India, Reserve Bank of India) is referred to as open market operations. Under this, central bank influences interest rates by selling government debt in the market which results in reduced cash in investor account, excess reserves with banks, fewer funds available for lending and reduced money supply thereby sucking liquidity from the system and led to tightening of the amount of money in circulation. However, it is pertinent to note that in the absence of a liquid market in government debt securities it is difficult to implement open market operations.
• Reserve Requirements: Banks are required to keep a certain amount of reserves with Central Bank in the form of CRR and SLR. By increasing the reserve requirement, the central bank effectively decreases the funds that are available for lending and the money supply which further led to an increase in interest rates.
• Policy Rate: Policy rate is basically the monetary tool used by the Central bank to control the money supply in the country. Prominent Policy rates are Repo Rate and Reverse Repo Rate. Repo Rate is the rate at which central bank lends money to Banks and Reverse Repo rate is the rate at which central bank borrows funds from the banks. By increasing the repo rate as part of contractionary monetary policy implement exercise, central bank makes the cost of borrowing high for banks which in turn compel banks to increase their lending rates resulting in the reduced supply of money.

Conclusions

Monetary Policy is often adjusted to reflect the source of inflation. Contractionary Monetary Policy is an appropriate response to combat inflation if inflation is above the target inflation (determined by Central Bank) caused due to higher aggregate demand (i.e. higher consumer spending and business investments), however the same contractionary monetary policy can result in serious ramification to the economy if it is implemented in such a case where monetary policy inflation is higher due to supply shocks (i.e. higher food and essential commodity prices) and an economy which is operating below full employment level.

The idea behind implementing a contractionary monetary policy is to make the opportunity cost of holding fund high so that people save more and spend less. Discouraging consumer spending by increasing interest rates helps in combating of the monetary policy inflation as it results in reduced demand but can also lead to increased unemployment due to less capital investment by business due to tighter money supply and high interest rates. Thus we can say that the effectiveness and success of the Contractionary monetary policy depend upon the consumer spending and investment pattern of the economy and execution capability of the central bank of that country.

Recommended Articles

This has been a guide to Contractionary Monetary Policy. Here we discuss Contractionary Monetary Policy tools (open market operations, changes in reserve requirements, policy rate) along with practical examples. You may learn more about Economics from the following articles –

• Quantitative Easing
• Fiscal Policy vs Monetary Policy
• What is Microeconomics?
• What is Behavioural Economics?

The post Contractionary Monetary Policy appeared first on Learn Investment Banking: Financial Modeling Training Courses Online.