Contractionary Policy


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.

BREAKING DOWN '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.

  1. Inflation

    The rate at which the general level of prices for goods and services ...
  2. Business Cycle

    The fluctuations in economic activity that an economy experiences ...
  3. Money Supply

    The entire stock of currency and other liquid instruments in ...
  4. Contraction

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

    The entity responsible for overseeing the monetary system for ...
  6. Federal Reserve Board - FRB

    The governing body of the Federal Reserve System. The seven members ...
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  1. What strategies can be used to achieve the goals of contractionary policy?

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