Contractionary Monetary Policy with Examples

Why Do Interest Rates Ever Need to Rise?

contractionary monetary policy
••• Contractionary monetary policy reduces the money supply. Photo: Peter Dazeley/Getty Images

Contractionary monetary policy is when a central bank uses its monetary policy tools to fight inflation. Since inflation is a sign of an overheated economy, the bank must slow economic growth. It will raise interest rates to make lending more expensive. It is also called restrictive monetary policy.

The U.S. central bank is the Federal Reserve. It has a target for inflation of 2 percent. If inflation is higher than that, it means the economy is overheating.

If it's slower than 2 percent, it says growth is sluggish.

The Fed measures inflation using the core inflation rate. Core inflation is year-over-year price increases minus volatile food and oil prices. The Consumer Price Index is the inflation indicator most familiar to the public. The Fed prefers the Personal Consumption Expenditures Price Index. It uses formulas that smooth out more volatility than the CPI does.

If the PCE Index for core inflation rises much above 2 percent, then the Fed implements contractionary monetary policy.

How Central Banks Implement Contractionary Monetary Policy 

The Fed raises interest rates by increasing the target for the fed funds rate. That increases the rate that banks charge each other to borrow funds to meet the reserve requirement. The Federal Reserve requires banks to have a specific reserve on hand each night. For most banks, that's 10 percent of their total deposits.

Without this requirement, banks would lend out every single every dollar people deposited. They wouldn't have enough cash in reserve to cover operating expenses if any of the loans defaulted.

Raising the fed funds rate is contractionary because it decreases the money supply. Banks charge higher interest rates on their loans to compensate for the higher fed funds rate.

Businesses borrow less, don't expand as much and hire fewer workers. That reduces demand. As people shop less, firms slash prices. Falling prices put an end to inflation.

The Fed also uses open market operations. That's when the Fed buys or sells its holdings of U.S. Treasury notes. To implement contractionary policy, the Fed sells Treasurys to one of its member banks. The bank must pay the Fed for the Treasurys on its books reduces. As a result, banks have less money available to lend. With less money to lend, they charge a higher interest rate. It has the same effect as raising the fed funds rate.

The Fed could increase the reserve requirement, but rarely does so. It's disruptive to banks to change procedures and regulations to meet a new requirement. Raising the fed funds rate is easier and achieves the same aim.

Effects

Higher interest rates make loans more expensive. As a result, people are less likely to buy houses, autos, and furniture. Businesses can't afford to expand. The economy slows. If not exercised with care, contractionary policy can push the economy into a recession

Examples 

There aren't many examples of contractionary monetary policy for two reasons. First, the Fed usually wants the economy to grow, not shrink.

More important, inflation hasn't been a problem since the 1970s. 

In 1973, inflation went from 3.9 percent to 9.6 percent. The Fed raised interest rates from 5.75 percent to 13 percent by July 1974. Despite inflation, economic growth was slow. That situation is called stagflation. The Fed responded to political pressure and dropped the rate to 7.5 percent in January 1975. The Fed's stop-go monetary policy sent inflation into the 10-12 percent range through April 1975. Businesses didn't lower prices when interest rates went down. They didn't know when the Fed would raise them again. When Paul Volcker became Fed Chair in 1979, he increased the fed funds rate to 20 percent. He kept it there, finally putting a stake through the heart of inflation.

Former Fed Chair Ben Bernanke said contractionary policy caused the Great Depression.

The Fed had instituted contractionary monetary policies to curb the hyperinflation of the late 1920s. But during the recession or stock market crash of 1929, it didn’t switch to expansionary monetary policy as it should have. It continued contractionary policy and raised rates.

It did so because dollars were backed by the gold standard. The Fed didn't want speculators to sell their dollars for gold and deplete the  reserves. An expansionary monetary policy would have created a little healthy inflation. Instead, the Fed protected the dollar's value and created massive deflation. That helped turn a recession into a decade-long depression

The Difference from Expansionary Monetary Policy

Expansionary monetary policy stimulates the economy. The central bank uses its tools to add to the money supply. It often does this by lowering interest rates. It can also use expansionary open market operations, called quantitative easing.

The result is an increase in the aggregate demand. It boosts growth as measured by gross domestic product.  It usually lowers the value of the currency, thereby decreasing the exchange rate.

Expansionary monetary policy deters the contractionary phase of the business cycle.  But it is difficult for policymakers to catch this in time. As a result, you typically see expansionary policy used after a recession has started.