Contractionary monetary policy refers to a policy that the finance ministry or the central bank of a country uses as a macro-economic tool in slowing down the economy. The policy is usually enacted by the government as a way of reducing its money supply as well as the spending of people in the country. This is achieved in various ways including increasing the interest rates, increasing the reserve requirements and reducing money supply indirectly or directly.
In most cases, contractionary monetary policy is enacted and implemented during the periods of high growth duration in a business cycle although it does not result in immediate effect.
In any economy, prices start increasing when there is high amount of money available and people are spending more money. This is what is called inflation. If a country experiences high inflation that anticipated, contractionary monetary policy can be implemented as a way of slowing down the economy. This policy aims at reducing spending through making acquiring loans less attractive or reducing the currency that is circulating. Thus, inflation is eventually reduced. It is important to note effectiveness of contractionary monetary policy is varies.
When the lending interest rates of the Federal Reserves are increased, lending interest rates for banks are also increased. When there are high interest rates, individuals find it expensive to access loans and this reduces the rate of spending among individuals in a country.
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To meet the withdrawal demands of the customers, banks should have cash reserves. When the banks have high cash reserves, they will have less money for lending out. This will also lower the amount of money being supplied or circulating.
In addition, the central bank can also borrow from individuals and institutions through different means such as bonds. If the central bank increases the interest that is paid on the bonds, more people will be interested in buying them. This implies that the amount of money that will be in circulation will be reduced.
Central bank may also reduce the amount of money that is lent out or even call in the existing debts so that it can reduce the amount of money that is supply. Nevertheless, just like other monetary policies, contractionary monetary policy has its side effects as well. The most important of the side effects of this policy is interest rates control. When the amount of money is decreased, banks charge higher interest rates for their loans.
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