What is a Contractionary Policy?

Contractionary policy is an approach or strategy that can be used by the central bank or financial regulatory agency of a given nation to control the forward movement of a nation’s economy. This strategy can be effectively used to slow movement in the event that the nation is moving rapidly toward an economic state that is considered undesirable, thus allowing financial analysts more time to develop other strategies that would either prevent the impending economic situation, or at least minimize its impact. At its core, contractionary policy makes it possible for the government to control the money supply that is in circulation, and thus control the spending that takes place within the nation.

While there are a number of strategies that can be used as part of a contractionary policy, most can be grouped under three specific master steps to the plan. One of these master steps has to do with inflating interest rates. The idea here is to increase the rates applied to various financial instruments, such as mortgages and other types of loans. Doing so helps to slow the spending of both businesses and private citizens, a measure that can in turn slow the movement of the economy in general.

Another factor that is often part of contractionary policy is making changes to the reserve requirements placed on banks operating within the nation. Adjusting the requirements upward actually has the effect of leaving the banks with fewer resources to devote to lending money. As a result, banks often tighten their lending policies to assume less risk. At the same time, fewer people can qualify for a loan, thus slowing the spending that takes place.

Taking steps to reduce the available money supply is also an approach used in various contractionary policy strategies. Here, the idea is to find ways to make spending less desirable for both individuals and businesses. This may include the imposition of taxes that consume additional funds, and leave less cash on hand to spend for goods and services. Reducing the types of loans offered by banks and other lending institutions will also slow the flow of money through the economy. A nation may also simply choose to take a portion of currency out of circulation, effectively reducing the overall money supply.

Often, contractionary policy is used to at least partially slow inflation within a given economy. When a nation is entering a period of inflation, taking steps to make it less desirable for consumers to spend money will help slow the rate of inflation, and thus provide more time to implement additional policies that over time minimize the impact of inflation on the overall economy. By using various methods to raise interest rates, make it harder to obtain loans, and in general slow consumer spending, it is easier to control the rate of inflation and also minimize the severity of the period of recession that is likely to follow the period of inflation at some point.