Contractionary Policy

AAA

DEFINITION of 'Contractionary Policy'

A type of policy that is used as a macroeconomic tool by the country's central bank or finance ministry to slow down an economy. Contractionary policies are enacted by a government to reduce the money supply and ultimately the spending in a country.

This is done primarily through:
1. Increasing interest rates
2. Increasing reserve requirements
3. Reducing the money supply, directly or indirectly

This tool is used during high-growth periods of the business cycle, but does not have an immediate effect.

INVESTOPEDIA EXPLAINS 'Contractionary Policy'

When both spending and the availability of money are high, prices start to rise - this is known as inflation. When a country is experiencing higher-than-anticipated inflation, the government might step in with a contractionary policy to try to slow down the economy. Their goal is to reduce spending by making it less attractive to acquire loans or by taking currency out of circulation, and thus reduce inflation. The effectiveness of these policies vary.

1. Increasing the interest rate at which the Federal Reserve lends will also increase the rates at which banks lend. When rates are higher, it is more expensive for individuals to obtain loans; this reduces spending.

2. Banks are required to keep a reserve of cash to meet withdrawal demands. If the reserve requirements are increased, there is less money for banks to lend out. Thus there is a lower money supply.

3. Central banks can borrow money from institutions or individuals in the form of bonds. If the interest paid on these bonds is increased, more investors will buy them. This will take money out of circulation. Central banks can also reduce the amount of money they lend out or call in existing debts to reduce the money supply.

RELATED TERMS
  1. Business Cycle

    The fluctuations in economic activity that an economy experiences ...
  2. Stabilization Policy

    A macroeconomic strategy enacted by governments and central banks ...
  3. Expansionary Policy

    A macroeconomic policy that seeks to expand the money supply ...
  4. Central Bank

    The entity responsible for overseeing the monetary system for ...
  5. Contraction

    A phase of the business cycle in which the economy as a whole ...
  6. Inflation

    The rate at which the general level of prices for goods and services ...
Related Articles
  1. The Federal Reserve
    Economics

    The Federal Reserve

  2. What Is Fiscal Policy?
    Economics

    What Is Fiscal Policy?

  3. Understanding Supply-Side Economics
    Economics

    Understanding Supply-Side Economics

  4. How Much Influence Does The Fed Have?
    Economics

    How Much Influence Does The Fed Have?

comments powered by Disqus
Hot Definitions
  1. Market Segmentation

    A marketing term referring to the aggregating of prospective buyers into groups (segments) that have common needs and will ...
  2. Effective Annual Interest Rate

    An investment's annual rate of interest when compounding occurs more often than once a year. Calculated as the following: ...
  3. Debit Spread

    Two options with different market prices that an investor trades on the same underlying security. The higher priced option ...
  4. Odious Debt

    Money borrowed by one country from another country and then misappropriated by national rulers. A nation's debt becomes odious ...
  5. Takeover

    A corporate action where an acquiring company makes a bid for an acquiree. If the target company is publicly traded, the ...
  6. Harvest Strategy

    A strategy in which investment in a particular line of business is reduced or eliminated because the revenue brought in by ...
Trading Center