Contractionary Monetary Policy
What is Contractionary Monetary Policy?
Contractionary monetary policy decreases the money supply to raise interest rates and reduce inflation.
The central bank sells bonds, raises the discount rate, or increases the reserve requirement. Higher interest rates reduce investment and consumption, shifting aggregate demand left. It is used to fight high inflation.
Contractionary Monetary Policy: a worked example
Inflation is running hot, so the central bank sells $30 billion of government bonds through an open market sale. With a required reserve ratio of 25 percent the money multiplier is 1 ÷ 0.25 = 4, so the money supply contracts by as much as 4 × $30 billion = $120 billion. Scarcer money drives the nominal interest rate from 4 percent to 6 percent. Firms here cut investment by $25 billion for each percentage point, so the 2 point rise removes 2 × $25 billion = $50 billion of investment spending. With an MPC of 0.5 the spending multiplier is 1 ÷ (1 − 0.5) = 2, and aggregate demand shifts left by 2 × $50 billion = $100 billion. Output and the price level both come down relative to their previous path, and unemployment rises, which is the short run cost of disinflation.
The mistake students make with contractionary monetary policy
A frequent slip is claiming that when the central bank sells bonds, bond prices rise alongside interest rates. Students reason that selling must make bonds more valuable, or they simply move both numbers the same direction. A sale adds to the supply of bonds available, which pushes bond prices down, and bond prices move inversely to yields, so falling prices mean rising interest rates. Reversing this flips the entire transmission chain and turns a contractionary answer into an expansionary one.
Contractionary Monetary Policy questions
When does a central bank use contractionary monetary policy?
Contractionary monetary policy answers an inflationary gap, where real GDP exceeds potential and the price level is climbing faster than the bank's target. A higher interest rate suppresses interest sensitive investment and consumption, pulling aggregate demand back toward potential output. The trade off is real. Slower demand growth means higher unemployment in the short run, which is why the timing and size of any tightening are contested.
How does selling bonds reduce the money supply?
Selling bonds moves securities from the central bank to banks and the public, and payment for them flows out of bank reserves. Fewer reserves mean fewer excess reserves to lend, and each dollar of lost reserves shrinks deposits by a multiple set by the money multiplier. Under a 20 percent reserve requirement, a $10 billion sale can pull as much as 5 × $10 billion = $50 billion out of the money supply.
What happens to unemployment under contractionary monetary policy?
Unemployment rises in the short run. Higher interest rates cut investment and interest sensitive consumption, aggregate demand shifts left, and firms facing weaker sales produce less and hire fewer workers. In the long run the economy returns toward the natural rate of unemployment at a lower price level, so the model treats the cost as temporary, though that transition is what makes tightening politically difficult.
Formula / Example
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