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Contractionary monetary policy is monetary policy that seeks to reduce the size of the money supply. In most nations, monetary policy is controlled by either a central bank or a finance ministry. Monetary policy is the process of managing money supply to achieve specific goals—such as constraining inflation, achieving full employment or economic growth. ...
The examples and perspective in this article do not represent a worldwide view. ...
The finance minister is a cabinet position in a government. ...
Neoclassical and Keynesian economics significantly differ on the effects and effectiveness of monetary policy on influencing the real economy; there is no clear consensus on how monetary policy effects real economic variables (aggregate output or income, employment). Both economic schools accept that monetary policy affects monetary variables (price levels, interest rates). Neoclassical economics refers to a general approach (a metatheory) to economics based on supply and demand which depends on individuals (or any economic agent) operating rationally, each seeking to maximize their individual utility or profit by making choices based on available information. ...
Keynes reading from his General Theory Keynesian economics (pronounced kaynzian), is an economic theory based on the ideas of John Maynard Keynes, as put forward in his book The General Theory of Employment, Interest and Money, published in 1936 in response to the Great Depression of the 1930s. ...
Monetary policy relies on a number of tools: monetary base, reserve requirements, discount window lending and interest rates. The money base, or the monetary base is a government liability, currency and bank reserves. ...
Reserve requirements, a tool of monetary policy, are computed as percentages of deposits that banks must hold as vault cash or on deposit at the central bank (in the United States in a Federal Reserve Bank), rather than, perhaps, lend out. ...
The discount window is used by a nations monetary authority to extend/cancel loans to financial institutions. ...
An interest rate is the price of money. ...
Policy Tools
Monetary Base Contractionary policy can be implemented by reducing the size of the monetary base. This directly reduces the total amount of money circulating in the economy. In the United States, the Federal Reserve can use open market operations to reduce the monetary base. The Federal Reserve would sell bonds in exchange for hard currency. When the Federal Reserve collects this hard currency payment, it removes that amount of currency from the economy, thus contracting the monetary base. Note that open market operations are a relatively small part of the total volume in the bond market, thus the Federal Reserve is not able to influence interest rates through this method. The Federal Reserve System is headquartered in the Eccles Building on Constitution Avenue in Washington, DC. The Federal Reserve System (also the Federal Reserve; informally The Fed) is the central banking system of the United States. ...
Open Market Operations are the means by which central banks control the liquidity of the national currency. ...
In finance, a bond is a debt security, that is the issuer owes the holders a debt and is obliged to pay the principal and interest (the coupon), together with other obligations under the term of the issue, such as the obligation to give certain information. ...
Reserve Requirements The monetary authority exerts regulatory control over banks. Contractionary policy can be implemented by requiring banks to hold a higher proportion of their total assets in reserve. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By requiring a higher proportion of total assets to be held as liquid cash, the Federal Reserve reduces the availability of loanable funds. This acts as a reduction in the money supply.
Discount Window Lending Many central banks or finance ministries have the authority to lend funds to financial institutions within their country. The lent funds represent an expansion in the monetary base. By calling in existing loans the monetary authority can directly reduce the size of the money supply. By advertising that the discount window will reduce future lending, the monetary can also indirectly reduce the money supply by reducing risk-taking by financial institutions.
Interest Rates Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In the United States, the Federal Reserve can only indirectly set the Federal Funds Rate by open market operations, discount lending, and changes in reserve reaquirement. This rate has some effect on other market interest rates, but there is no direct, definite relationship. In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By raising the interest rate(s) under its control, a monetary authority can contract the money supply, because higher interest rates encourage savings and discourage lending. Both of these effects reduce the size of the money supply. The federal funds rate is the interest rate at which depository institutions lend balances (federal funds) at the Federal Reserve to other depository institutions overnight. ...
The examples and perspective in this article do not represent a worldwide view. ...
Monetary Policy and Inflation Monetary policy can be used to control inflation. Inflation is defined as continuing increases in price levels. Since price level is a monetary variable, monetary policy can affect it. Contractionary monetary policy has the effect of reducing inflation by reducing upward pressure on price levels.
Note that inflation can also be affected by fiscal policy. However, contractionary fiscal policy is often politically unpopular, because it involves spending cuts and tax increases. Thus, politicians favor the use of monetary policy to control inflation. Fiscal Policy is the economic term which describes the behaviour of governments in raising money to fund current spending and investment for collective social purposes and for transfer payments to citizens and residents of the territory for which the government is responsible. ...
Monetary Policy and the Real Economy As noted above, the relationship between monetary policy and the real economy is uncertain. It is important to note that contractionary monetary policy should not be confused with economic contraction. The latter being a reduction in economic output in the real economy.
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