What is a Contractionary Monetary Policy?

Monetary policy represents the laws and regulations that a nation imposes in its economy to ensure a smooth flow of money and a stable environment for economic transactions. A contractionary monetary policy will remove the money from the economy; this is also known as decreasing the supply of money. Nations engage in this policy to prevent inflation and “cool off” periods of excessive growth. Running a loose monetary policy will often result in high inflation, which is classically defined as too much money chasing too few goods.

In most developed countries, governments will use a central bank or other regularity agency to set the monetary policy for their countries. This institution is full of economists and others trained to review economic information and determine whether a contractionary monetary policy is necessary. These individuals look at economic indicators, such as purchasing power, consumer and wholesale inflation, or the credit markets, to determine when to implement this policy. Many countries find it difficult to pinpoint the exact timing for a contractionary monetary policy, partly because economic indicators will only focus on historical information. This can result in slowing down an economy too early and reducing economic transactions to a dangerously low level.

A central bank or other government agency may use interest rates to implement a contractionary monetary policy. Interest rates dictate how much banks must pay when borrowing money from the central bank, as well as rates charged on loans between commercial banks and the amount of interest banks can charge to consumers for loans and mortgages. Raising these interest rates will increase the cost to borrow money, effectively instituting a contractionary monetary policy. Banks are typically loathe to borrow money when their costs, money paid based on loan interest rates, go above certain levels. As banks engage in fewer loans, the money supply in the market declines and fewer transactions will occur. Additionally, current loans may have adjustable rates that reflect the changes in national interest rates, making the cost of current loans more expensive.

Another way nations can implement a contractionary monetary policy is to sell bonds to investors. Government bonds will result in businesses and consumers giving money to the government in exchange for the bonds. This reduces the amount of money in the economy and results in fewer opportunities for individuals to engage in economic transactions. Governments will often use this policy as they can also increase the money supply slowly, albeit more quickly than other methods for increasing money supply, by selling bonds, which represents loosening the contractionary policy.