Through the buying and selling of government bonds and other securities, the government is able to manage their monetary policy. This is known as open market operations, a commonly used tool by government bodies around the world. Through open market operations, the government would buy or sell securities in order to influence money supply, level of interest rates and the behavior of the overall economy. An contractionary monetary policy is the reverse of expansionary monetary policy.
Contractionary Monetary Policy: Tightening the Economy
When the government is looking to cool down a overheating economy, they will embrace a contractionary monetary policy. This type of policy is intended to lower the money supply in the economy and fight inflation. A high inflation is an indicator of an economy running at full capacity. To reduce the inflation, the government would typically increase the interest rates, raise bank reserve requirements and sell government securities.
- Increase Interest Rates – The central bank would aim to reduce the money supply by increasing the interest rates. This would result in less borrowing by consumers as banks would raise interest rates that they charge to clients.
- Increase Reserve Requirements – Banks are required to hold a minimum amount of financial reserves with the central bank. To reduce the money supply, the central bank would raise the reserve requirements. This would affect the number of loans that banks can hand out to consumers.
- Sell Government Securities – The government would reduce the money supply by selling government bonds to institutional investors. This open market operations would reduce the amount of money circulating in the economy.
Through a contractionary monetary policy, the government is able to:
- Reduce Inflation – Through a tightening monetary policy, the government’s goal is to reduce inflation and cool down the economy. By reducing the money supply, the prices of goods and services can be stabilized.
- Cool Down Economic Growth – The reduction of money supply cools down the economy. Consumers and businesses lower their spending and capital investments which in turn slows down production of goods and services.
- Increase Unemployment – The cooling down of the economy comes at an expense of increased unemployment. As companies slow down their production of goods and services, this in turns causes a rise in unemployment as less people are spending. Unemployment and contraction monetary policies are positively correlated.
