Contractionary Monetary Policy

by Stephan Smith on December 7, 2010

Get ready for another one of those very intimidating terms used by central bankers all over the world. That term is contractionary monetary policy. Now before your eyes glaze over, I want you to really focus and read this page, because by doing so you will learn what contractionary monetary policy is, what affect it has on an economy and how it is implemented by central banks. Monetary policy in general has profound affects on an economy and your life, so knowing what central banks are doing and the monetary policies they’re implementing can help you prepare for possible financial difficulties and financial prosperity. With that said, get ready to learn what contractionary monetary policy is.

Contractionary Monetary Policy Explained

Contractionary monetary policy is a type of monetary policy implemented by central banks that decreases the money supply of an economy and thus makes money and credit less accessible to individuals and businesses in an effort to combat inflation.

The primary duty of a central bank is to ensure price stability. That is, to protect the value of the currency that is issued. In the case of the Federal Reserve System, which is the central bank of the United States, the FED’s number one responsibility is to protect the value of the United States dollar. The same duties apply to the European Central Bank protecting the value of the Euro, the Bank of England protecting the value of the British Pound, the Bank of Japan protecting the value of the Japanese Yen and so on. The duty of protecting the value of currency applies to all central banks everywhere. So, whenever a central bank implements expansionary monetary policy actions at too great of a degree, the money supply of an economy will eventually become greater than the demand for money and thus inflation becomes the result.

Remember, inflation and hyperinflation are the results of having too much money available in an economy’s money supply. Money is added to the money supply of an economy by implementing expansionary monetary policies such as quantitative easing, reinvesting central bank earnings and even lowering commercial bank reserve requirements which would allow commercial banks to expand the money supply further. Once inflation becomes elevated a central bank would have to start to consider implementing contractionary monetary policies.

The affects of contractionary monetary policies on an economy is the complete antithesis of the affects dealt by expansionary monetary policies to an economy. Also known as tightening monetary policy, contractionary monetary policy looks to assist an economy undergo disinflation by decreasing the supply of money and credit. So how exactly does decreasing the money supply of an economy affect an economy? With money and credit becoming more difficult to obtain, it slows an economy’s growth. Loans become more expensive, businesses may not hire as many employees and consumers will start to curve spending all because money and credit become more scarce. Generally, the economy starts to slow down the output of goods and services as well. It may seem like contractionary monetary policy is a bad thing, but if inflation was allowed to persist, then greater economic woes would be realized.

How Contractionary Monetary Policy is Implemented

Ok, I hope you have a good idea of what contraction monetary policy is and how it affects an economy. Next I am going to explain how a central bank implements contractionary monetary policies.

The primary way a central bank implements contractionary monetary policies is by ceasing to buy securities and selling securities which are own by the central bank. A central bank can sell what ever securities it has in it’s holdings to the open market. Once it receives money for the securities sold, a central bank can place that money in its reserves. By doing that, that money is now out of circulation and has been removed from the economy’s money supply. Don’t forget, contractionary monetary policy involves the removal of money from an economy’s money supply. That is done by a central bank selling securities it owns to the market and taking the money out of the economy.



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{ 3 comments… read them below or add one }

eeeeee May 22, 2012 at 10:08 AM

thank you this website is very helpfull

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Stephan Smith May 22, 2012 at 1:45 PM

I’m glad this article has been helpful for you. Come back anytime.

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shanton March 10, 2012 at 10:21 PM

Thanks u so much, this was like a face to face lecture.

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