What is a {term}? Contractionary Policy

Contractionary policy refers to either a reduction in government spending, particularly deficit spending, or a reduction in the rate of monetary expansion by a central bank. It is a type of policy or macroeconomic tool designed to combat rising inflation or other economic distortions created by central bank or government interventions. Contractionary policy is the opposite of expansionary policy.

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What Is Contractionary Policy?

BREAKING DOWN Contractionary Policy

The goal of contractionary policy is not to slow down economic growth. Instead, contractionary policies are used to slow down potential distortions such as high inflation from an expanding money supply, unreasonable asset prices or crowding-out effects in capital markets. The initial effect of contractionary policy might be a reduction in nominal gross domestic product, but the final result could be higher and more sustainable economic growth and a smoother business cycle.

A notable use of contractionary policy occurred in the early 1980s when the then-Federal Reserv chairman Paul Volcker ended the soaring inflation of the 1970s. At their peak in 1981, target federal fund interest rates were close to 20 percent. Measured inflation levels declined from nearly 14 percent in 1980 to 3.2 percent in 1983.

Contractionary Policy as Fiscal Policy

Governments engage in contractionary fiscal policy by raising taxes or reducing government spending. In their crudest form, these policies are designed to siphon money out of the private economy in the hopes of slowing down unsustainable production or lowering asset prices. In modern times, an increase in the tax level is rarely seen as a viable contractionary measure. Instead, most contractionary fiscal policies unwind a previous fiscal expansion by reducing government expenditures – and even then only in targeted sectors.

If contractionary policy reduces the level of crowding out in the private markets, it may create a stimulating effect by growing the private, or non-governmental, portion of the economy. For example, huge boosts in economic growth followed massive cuts in government spending and rising interest rates during the Forgotten Depression of 1920 to 1921 and after the end of World War II.

Contractionary Policy as Monetary Policy

Contractionary monetary policy is driven by increases in the various base interest rates controlled by modern central banks or other means, producing growth in the money supply or the total level of the money supply. The goal is to reduce inflation by limiting the amount of active money in the economy, or to stop unsustainable speculation or capital investment that previous expansionary policy might have caused.

In the United States, contractionary policy is usually 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 can also raise reserve requirements for member banks, shrinking the money supply, or perform open-market operations by selling assets, such as U.S. Treasuries, to large investors. This lowers the market price of such assets and increases their yields, making it more economical for savers and bondholders.