Inflation occurs when an economy grows due to increased spending. When this happens, prices rise and the currency within the economy is worth less than it was before; the currency essentially won’t buy as much as it would before. When a currency is worth less, its exchange rate weakens when compared to other currencies.
There are many methods used to control inflation; some work well while others may have damaging effects. For example, controlling inflation through wage and price controls can cause a recession and cause job losses.
One popular method of controlling inflation is through a contractionary monetary policy. The goal of a contractionary policy is to reduce the money supply within an economy by decreasing bond prices and increasing interest rates. This helps reduce spending because when there is less money to go around, those who have money want to keep it and save it, instead of spending it. It also means that there is less available credit, which can also reduces spending. Reducing spending is important during inflation, because it helps halt economic growth and, in turn, the rate of inflation.
There are three main tools to carry out a contractionary policy. The first is to increase interest rates through the central bank, in the case of the U.S., that's the Federal Reserve. The Fed Funds Rate is the rate at which banks borrow money from the government, but, in order to make money, they must lend it at higher rates. So, when the Federal Reserve increases its interest rate, banks have no choice but to increase their rates as well. When banks increase their rates, fewer people want to borrow money because it costs more to do so while that money accrues at a higher interest. So, spending drops, prices drop and inflation slows.
The second tool is to increase reserve requirements on the amount of money banks are legally required to keep on hand to cover withdrawals. The more money banks are required to hold back, the less they have to lend to consumers. If they have less to lend, consumers will borrow less, which will decrease spending.
The third method is to directly or indirectly reduce the money supply by enacting policies that encourage reduction of the money supply. Two examples of this include calling in debts that are owed to the government and increasing the interest paid on bonds so that more investors will buy them. The latter policy raises the exchange rate of the currency due to higher demand and, in turn, increases imports and decreases exports. Both of these policies will reduce the amount of money in circulation because the money will be going from banks, companies and investors pockets and into the government’s pocket where it can control what happens to it.
-
What is the purpose for issuing contractionary policy?
Learn the purpose of contractionary policy. Contractionary policy can be enacted by governments through fiscal channels and ... Read Answer >> -
How does fiscal policy impact the budget deficit?
Find out how the different uses of fiscal policy impact a government's budget deficit, and the difference between contractionary ... Read Answer >> -
Why would the Federal Reserve change the reserve ratio?
Understand the Federal Reserve's monetary policy and the tools it uses to change that monetary policy. Learn about the reserve ... Read Answer >> -
How does monetary policy impact the cost of debt?
Learn how monetary policy impacts the cost of debt. This economics lesson explains how the Federal Reserve influences interest ... Read Answer >> -
How Do Fiscal and Monetary Policies Affect Aggregate Demand?
Learn about the impact fiscal and monetary policy have on aggregate demand, and discover how the government influences economic ... Read Answer >>
-
Insights
9 Common Effects of Inflation
Is inflation ever good? If you like your job it is. -
Investing
How Do Interest Rates Affect the Stock Market?
Interest rates can have a complicated ripple effect through financial markets. Here's what you need to know. -
Insights
How Central Banks Control the Supply of Money
A look at the ways central banks pump or drain money from the economy to keep it healthy. -
Insights
How Much Influence Does The Fed Have?
Find out how current financial policies may affect your portfolio's future returns. -
Insights
The Importance Of Inflation And GDP
Learn the underlying theories behind these concepts and what they can mean for your portfolio. -
Trading
How CPI Affects the Dollar Against Other Currencies
The Consumer Price Index is a broad measure of inflation, and inflation can have a dramatic impact on a currency's value against rival currencies. -
Insights
What is Fiscal Policy?
Learn how governments adjust taxes and spending to moderate the economy, also known as fiscal policy. -
Personal Finance
How the Federal Reserve Affects Your Mortgage
The Federal Reserve can impact the cost of funds for banks and consequently for mortgage borrowers when maintaining economic stability. -
Insights
How the Federal Reserve Affects Individual Investors
The Federal Reserve's decision on interest rates affects the whole economy.
-
Contractionary Policy
A type of policy that is used as a macroeconomic tool by the ... -
Monetary Policy
Monetary policy is the actions of a central bank, currency board ... -
Inflation
The rate at which the general level of prices for goods and services ... -
Inflation Trade
An inflation trade is an investing scheme or trading method that ... -
Accommodative Monetary Policy
Accommodative monetary policy occurs when a central bank attempts ... -
Money Supply
The entire stock of currency and other liquid instruments in ...