What Is a Contractionary Policy?
Contractionary policy is a monetary measure alluding either to a reduction in government spending — especially deficit spending — or a reduction in the rate of monetary expansion by a central bank. It is a type of macroeconomic device intended to combat rising inflation or other economic mutilations made by central banks or government intercessions. Contractionary policy is the perfect inverse of expansionary policy.
A Granular View of Contractionary Policy
Contractionary policies aim to frustrate likely mutilations to the capital markets. Mutilations incorporate high inflation from an extending money supply, unreasonable asset prices, or crowding-out effects, where a spike in interest rates prompts a reduction in private investment spending to such an extent that it hoses the initial increase of total investment spending.
While the initial effect of the contractionary policy is to reduce nominal gross domestic product (GDP), which is defined as the gross domestic product (GDP) assessed at current market prices, it frequently at last outcomes in sustainable economic growth and smoother business cycles.
Contractionary policy strikingly happened in the mid 1980s when the then-Federal Reserve chair Paul Volcker at last ended the taking off inflation of the 1970s. At their top in 1981, target federal fund interest rates neared 20%. Measured inflation levels declined from almost 14% in 1980 to 3.2% in 1983.
Contractionary Policy as Fiscal Policy
Governments take part in contractionary fiscal policy by increasing government rates or diminishing government spending. In their crudest form, these policies siphon money from the private economy, bearing in mind the end goal of dialing back unsustainable production or bringing down asset prices. In modern times, an increase in the tax level is rarely viewed as a viable contractionary measure. All things being equal, most contractionary fiscal policies loosen up previous fiscal expansion, by diminishing government consumptions — and, surprisingly, then, at that point, just in targeted sectors.
In the event that contractionary policy reduces the level of crowding out in the private markets, it might make an invigorating effect by developing the private or non-governmental portion of the economy. This bore true during the Forgotten Depression of 1920 to 1921 and during the period straightforwardly following the finish of World War II when leaps in economic growth followed huge cuts in government spending and rising interest rates.
Contractionary policy is frequently associated with monetary policy, with central banks like the U.S. Federal Reserve, able to authorize the policy by raising interest rates.
Contractionary Policy as a Monetary Policy
Contractionary monetary policy is driven by increases in the different base interest rates controlled by modern central banks or different means creating growth in the money supply. The objective is to reduce inflation by restricting the amount of active money circulating in the economy. It additionally aims to suppress unsustainable speculation and capital investment that previous expansionary policies might have set off.
In the United States, a contractionary policy is normally performed by raising the target federal funds rate, which is the interest rate banks charge each other overnight, to meet their reserve requirements.
The Fed may likewise raise reserve requirements for member banks, in a bid to shrink the money supply or perform open-market operations, by selling assets like U.S. Treasuries, to large investors. This large number of sales brings down the market price of such assets and increases their yields, making it more economical for savers and bondholders.
Contractionary Policy Example
For a real illustration of a contractionary policy at work, look no farther than 2018. As reported by Dhaka Tribune, Bangladesh Bank announced plans to issue a contractionary monetary policy with an end goal to control the supply of credits and inflation and at last keep up with economic stability in the country. As the economic situation changed in subsequent years, the bank switched over completely to a monetary policy zeroed in on expansion.
- Contractionary policies are macroeconomic instruments intended to combat economic mutilations brought about by an overheating economy.
- Contractionary policies aim to reduce the rates of monetary expansion by setting a few boundaries for the flow of money in the economy.
- Contractionary policies are commonly issued during times of extreme inflation or when there has been a period of increased speculation and capital investment energized by prior expansionary policies.