Contractionary Monetary Policy: Slowing the Economy Down

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  • 0:05 An Inflationary Economy
  • 2:43 Contractionary Monetary Policy
  • 3:50 Monetary Policy Tools…
  • 5:15 How Contractionary…
  • 7:48 Lesson Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

In this lesson, you'll find out more about the central bank's efforts to deal with an overheating economy, what economists call 'contractionary monetary policy.'

An Inflationary Economy

The government has delegated the authority to the central bank to oversee the supply of money in the economy in order to achieve the goals of sustainable economic growth, high employment and stable prices. In an effort to achieve these goals, the central bank constantly monitors the economy using various indicators and either adds or subtracts from the money supply. In this lesson, we'll take a closer look at an inflationary economy that is developing in the town of Ceelo and then see how the central bank uses its monetary policy tools to fight the enemy of inflation.

When actual economic output is above its potential, we call this an expansionary gap, although it's sometimes referred to as an 'inflationary gap' because inflation is the central problem and the enemy that must be defeated.

Let's look at it on a personal level. Suppose that last year, Lydia the factory worker earned $500 per week in take-home pay. Let's say that in a typical week, she buys one basket of food, two baskets of household products and three cases of mineral water. This year, she received a raise, and now takes home $600 per week, which sounds great, doesn't it? When Lydia got her first $600 check, a gigantic smile came across her face as she quickly imagined buying six pairs of designer jeans and a bracelet with a golden basket charm on it.

However, her excitement quickly turned to sadness when she learned that all the prices in the economy rose by the same proportion as her paycheck did. Instead of buying the extra jeans and the bracelet, Lydia can still only afford to buy what she bought before the raise. Inflation is clearly a problem, and this is the perfect time for monetary policy to come to the rescue.

Contractionary Monetary Policy

Contractionary monetary policy is a policy used by monetary authorities to contract the money supply and reduce economic activity by raising interest rates to slow the rate of borrowing by companies, individuals and banks.

A sustained rise in the prices of goods and services, otherwise called inflation, reduces the purchasing power of every dollar and steals the benefit of higher wages. So, people may get raises and bonuses - like we talked about with Lydia - but prices for everyday items that people need or want are also more expensive - so in the end, nobody benefits. When the economy expands too fast, the enemy of inflation shows up, and monetary policy leaders use contractionary monetary policy. That's what this lesson is all about.

Monetary Policy Tools Used to Contract the Economy

When the central bank pursues contractionary monetary policy, they have several options available to them that they can use one at a time or in combination, if they want. Contractionary monetary policy includes:

  • Selling U.S. Treasury securities in the open market (that would be what we would call open market operations)
  • Raising the reserve requirements
  • Increasing the discount rate

The central bank raises interest rates by contracting the money supply through open market operations. Specifically, they sell U.S. Treasury securities, or government bonds, in the open market. What does this do? This immediately causes the federal funds rate to rise.

In addition, the Fed can raise the amount of reserves it requires commercial banks to hold, which is called raising the reserve requirement. Finally, it can increase the rate that it charges banks who want to borrow directly from the central bank. This is called increasing the discount rate.

How Contractionary Monetary Policy Works

Contractionary monetary policy reduces the amount of circulating money, which raises interest rates.
Contractionary Monetary Policy

We have three different tools that are all part of contractionary monetary policy that are helping to slow down the economy. All three of these tools, used separately or together, decrease the amount of money in circulation, which raises interest rates.

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