What Is a Contractionary Policy?

Contractionary policy is a monetary measure referring either to 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 macroeconomic tool designed to combat rising inflation or other economic distortions created by central banks or government interventions. Contractionary policy is the polar opposite of expansionary policy.

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What Is Contractionary Policy?

Key Takeaways

  • Contractionary policies are macroeconomic tools designed to combat economic distortions caused by an overheating economy.
  • Contractionary policies aim to reduce the rates of monetary expansion by putting some limits on the flow of money in the economy.
  • Contractionary policies are typically issued during times of extreme inflation or when there has been a period of increased speculation and capital investment fueled by prior expansionary policies.

A Granular View of Contractionary Policy

Contractionary policies aim to hinder potential distortions to the capital markets. Distortions include high inflation from an expanding money supply, unreasonable asset prices, or crowding-out effects, where a spike in interest rates leads to a reduction in private investment spending such that it dampens the initial increase of total investment spending.

While the initial effect of the contractionary policy is to reduce nominal gross domestic product (GDP), which is defined as the gross domestic product (GDP) evaluated at current market prices, it often ultimately results in sustainable economic growth and smoother business cycles.

Contractionary policy notably occurred in the early 1980s when the then-Federal Reserve chairman Paul Volcker finally ended the soaring inflation of the 1970s. At their peak in 1981, target federal fund interest rates neared 20%. Measured inflation levels declined from nearly 14% in 1980 to 3.2% 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 siphon money from the private economy, with 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 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. This bore true during the Forgotten Depression of 1920 to 1921 and during the period directly following the end of World War II when leaps in economic growth followed massive cuts in government spending and rising interest rates.

Contractionary policy is often connected to monetary policy, with central banks such as the U.S. Federal Reserve, able to enact the policy by raising interest rates.

Contractionary Policy as a 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. The goal is to reduce inflation by limiting the amount of active money circulating in the economy. It also aims to quell unsustainable speculation and capital investment that previous expansionary policies may have triggered.

In the United States, a contractionary policy is typically performed by raising the target federal funds rate, which is the interest rate banks charge each other overnight, in order to meet their reserve requirements.

The Fed may also raise reserve requirements for member banks, in a bid to shrink the money supply or perform open-market operations, by selling assets like U.S. Treasuries, to large investors. This large number of sales lowers the market price of such assets and increases their yields, making it more economical for savers and bondholders.

Contractionary Policy Example

For an actual example of a contractionary policy at work, look no further than 2018. As reported by Dhaka Tribune, Bangladesh Bank announced plans to issue a contractionary monetary policy in an effort to control the supply of credits and inflation and ultimately maintain economic stability in the country. As the economic situation changed in subsequent years, the bank converted to a monetary policy focused on expansion.