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. Money Supply

    The entire stock of currency and other liquid instruments in ...
  3. Central Bank

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

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

    The rate at which the general level of prices for goods and services ...
  6. Federal Reserve Board - FRB

    The governing body of the Federal Reserve System. The seven members ...
RELATED FAQS
  1. What methods can the government use to control inflation?

      Inflation is when the economy grows due to increased spending. When this happens, prices rise and the currency within the ... Read Full Answer >>
  2. How does the government influence the securities market?

    Governments generally say they don't like to take an active role in the securities market (except for regulating it); however, ... Read Full Answer >>
Related Articles
  1. Economics

    The Federal Reserve

    Few organizations can move the market like the Federal Reserve. As an investor, it's important to understand exactly what the Fed does and how it influences the economy.
  2. Economics

    What Is Fiscal Policy?

    Learn how governments adjust taxes and spending to moderate the economy.
  3. Economics

    Understanding Supply-Side Economics

    Does the amount of goods and services produced set the pace for economic growth? Here are the arguments.
  4. Economics

    How Much Influence Does The Fed Have?

    Find out how current financial policies may affect your portfolio's future returns.
  5. Personal Finance

    How The U.S. Government Formulates Monetary Policy

    Learn about the tools the Fed uses to influence interest rates and general economic conditions.
  6. Personal Finance

    What Are Central Banks?

    They print money, they control inflation, and much, much more. All you need to know about central banks is here.
  7. Economics

    What's The Impact On Equities If The Rates Hike?

    The Fed is on course for raising interest rates. True, that leaves the question of when (most likely June or September, but could be later) and how much.
  8. Stock Analysis

    Why Should You Invest In Stratasys Today?

    When Stratasys pre-announced its fourth-quarter earnings, management highlighted that its MakerBot acquisition was underperforming expectations.
  9. Bonds & Fixed Income

    Why Didn't Quantitative Easing Lead To Hyperinflation?

    Hyperinflation is an exponential rise in prices and tends to occur not when countries print too much money, but is instead associated with a collapse in the real underlying economy.
  10. Investing

    What Has Been Groupon’s Growth Strategy?

    Groupon established a strategy with efforts to become a broader force in the e-commerce world and to expand more strongly into international markets.

You May Also Like

Hot Definitions
  1. Fixed Cost

    A cost that does not change with an increase or decrease in the amount of goods or services produced. Fixed costs are expenses ...
  2. Subsidy

    A benefit given by the government to groups or individuals usually in the form of a cash payment or tax reduction. The subsidy ...
  3. Sunk Cost

    A cost that has already been incurred and thus cannot be recovered. A sunk cost differs from other, future costs that a business ...
  4. Technical Skills

    1. The knowledge and abilities needed to accomplish mathematical, engineering, scientific or computer-related duties, as ...
  5. Prepaid Expense

    A type of asset that arises on a balance sheet as a result of business making payments for goods and services to be received ...
  6. Gordon Growth Model

    A model for determining the intrinsic value of a stock, based on a future series of dividends that grow at a constant rate. ...
Trading Center