What is a Contractionary Policy?
A contractionary policy serves as a vital economic measure aimed at reducing government spending or the rate of monetary expansion by central banks. Utilized primarily to combat inflation, this macroeconomic tool is crucial in maintaining economic balance.
The primary contractionary policies used by the United States government include increasing interest rates, raising bank reserve requirements, and selling government securities.
Key Takeaways
- Macroeconomic Stability: Contractionary policies are designed to address the distortions an overheated economy can create.
- Monetary Control: They work by limiting the money flow within the economy.
- Strategic Timing: These policies are often implemented during periods of severe inflation or after extensive speculation and investment triggered by previous expansionary measures.
Understanding Contractionary Policies
Contractionary policies are central in mitigating potential market distortions such as high inflation, unreasonable asset prices, and crowding-out effects that could dampen private investment spending due to increased interest rates.
While a contractionary policy initially reduces nominal gross domestic product (GDP), which is essentially GDP evaluated at current market prices, it ultimately fosters sustainable growth and smoother business cycles.
A notable instance of contractionary policy occurred in the early 1980s when the Federal Reserve chair, Paul Volcker, took measures to end the skyrocketing inflation of the 1970s. By 1981, target federal fund interest rates had approached 20%, subsequently decreasing inflation from nearly 14% in 1980 to 3.2% in 1983.
Tools Used for Contractionary Policies
Both monetary and fiscal tools are pivotal in combating inflation and managing economic contraction.
Monetary Policy
- Raising Interest Rates: By increasing interest rates, the availability of money circulating in the economy is limited, thereby reducing inflation, speculation, and capital investment.
- Increasing Reserve Requirements: Higher reserve requirements mean banks have fewer funds available for consumer and business loans.
- Selling Government Securities: The Federal Reserve uses open-market operations to sell assets like U.S. Treasury notes, lowering their market price and increasing yields.
Fiscal Policy
- Increasing Taxes: This reduces the money supply and purchasing power, particularly targeting unsustainable production or asset valuation.
- Reducing Government Spending: Cutting down on subsidies, welfare programs, public works projects, and the number of government employees can significantly shrink the money supply.
Real-World Example
During the COVID-19 pandemic, significant fiscal stimuli were deployed to boost consumption, inadvertently causing supply chain bottlenecks and price pressures. As the economy rebounded, signs of inflation emerged by 2022. To curb this, the Federal Reserve raised the target range for federal funds rates, aiming to return long-term inflation to 2%.
Contractionary Policy vs. Expansionary Policy
While contractionary policies focus on slowing the economy and reducing the money supply to combat inflation, expansionary policies aim to stimulate economic growth by increasing demand through monetary and fiscal interventions.
Effects of Contractionary Policy
Typically, contractionary policy results in tightened credit, higher unemployment, decreased business investment, reduced consumer spending, and overall contraction in the gross domestic product (GDP).
Main Goal of Contractionary Policy
The central aim is to decelerate growth to a sustainable economic level, often framed between 2% to 3% annual GDP growth. Excessive growth beyond this threshold risks triggering inflation and other negative economic impacts.
Challenges of Contractionary Policy
Implementing contractionary policies often means raising taxes and cutting government spending, including essential social and welfare programs, which are generally unpopular with voters.
Conclusion
Contractionary policy offers a way to curtail government spending or slow the pace of monetary expansion by central banks, primarily to counteract rising inflation. Key methods in the U.S. comprise raising interest rates, increasing bank reserve requirements, and selling government securities. Though challenging to enact due to potential tax increases, higher unemployment rates, and reduced government programs, they are pivotal for long-term economic health and stability.
Related Terms: expansionary policy, monetary supply, monetary policy, fiscal policy, gross domestic product.
References
- Federal Reserve History. “Volcker’s Announcement of Anti-Inflation Measures”.
- Federal Reserve Bank of St. Louis. “Inflation, Consumer Prices for the U.S.”
- U.S. Federal Reserve Board. “Fiscal Policy and Excessive Inflation During COVID-19: a Cross Country View”.
- U.S. Federal Reserve Board. “Federal Reserve Issues FOMC Statement”.
