June 24, 2024 

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A form of monetary policy in which a decrease in the money supply and a increase in interest rates are used to correct the inflationary problems of a business-cycle expansion. In theory, contractionary monetary policy can include selling U.S. Treasury securities through open market operations, an increase in the discount rate, and an increase in reserve requirements. In theory, open market operations are the primary tool of contractionary monetary policy. Contractionary monetary policy is often supported by contractionary fiscal policy. An alternative is expansionary monetary policy.
Contractionary monetary policy is a decrease in the quantity of money in circulation, with corresponding increases in interest rates, for the expressed purpose of putting the brakes on an overheated business-cycle expansion and to address the problem of inflation. In days gone by, monetary policy was undertaken by decreasing the amount of paper currency in circulation. In modern economies, monetary policy is undertaken by controlling the money creation process performed through fractional-reserve banking.

The Federal Reserve System (or the Fed) is U.S. monetary authority responsible for monetary policy. In theory, it can control the fractional-banking money creation process and the money supply through open market operations (selling U.S. Treasury securities), a higher discount rate, and higher reserve requirements. In practice, the Fed primarily uses open market operations for this control.

An important side effect of contractionary monetary policy is control of interest rates. As the quantity of money decreases, banks are willing to make loans at higher interest rates.

Open Market Operations

Open market operations are the buying and selling of U.S. Treasury securities as a means of controlling bank reserves, the money supply, and interest rates. This policy tool is directed by the Federal Open Market Committee and implemented by the Domestic Trading Desk of the New York Federal Reserve Bank. Because open market operations are flexible, easily implemented, and quite effective they are the Fed's primary monetary policy tool.

Contractionary monetary policy occurs when the Fed sells U.S. Treasury securities through open market operations. The Fed collects payment for the Treasury securities sold with bank reserves, which results in a decrease in total amount of reserves held by the banking system. Banks are inclined to reduce lending with fewer reserves, and charge higher interest rates, which decreases checkable deposits and the money supply.

Discount Rate

The discount rate is the interest rate that the Federal Reserve System charges commercial banks for reserve loans. The Federal Reserve System was established in part to provide commercial banks on the brink of failing with reserve loans. The discount rate is officially set by the Federal Reserve Banks, subject to approval by the Board of Governors. In practice, though, changes in the discount rate are coordinated with other monetary policy actions.

Contractionary monetary policy occurs when the Fed raises the discount rate. This makes it harder for commercial banks to borrow reserves from the Fed. As with open market operations, the resulting reduction in bank reserves held by the banking system induces fewer loans at higher interest rates, which decreases checkable deposits and the money supply.

However, because commercial banks do not undertake a great deal of reserve borrowing from the Fed, an increase in the discount rate alone is likely to have a limited impact on the money supply. For this reason, the discount rate is used primarily as a signal for other monetary actions, especially open market operations.

Reserve Requirements

Reserve requirements are rules by the Fed specifying the amount of reserves that banks must keep to back up deposits. Reserve requirements are generally in the range of about 10 percent of checkable deposits and 0 percent of savings deposits. The primary reason for reserve requirements is to maintain the stability of the banking system and to avoid bank panics and other problems created when banks run short of reserves. The Board of Governors has authority over setting reserve requirements.

Contractionary monetary policy occurs when the Fed raises reserve requirements. This means banks need to devote more reserves to back up deposits. This forces banks to make fewer loans at higher interest rates, which decreases checkable deposits and the money supply.

Reserve requirements are an important part of the structure of the banking system. Banks commit to long-term, multi-year loans based on existing and expected reserve requirements. If the Fed changed reserve requirements frequently, then either the banking system will be unstable or banks will simply target the highest expected reserve requirements. For this reason, reserve requirements are seldom used as a monetary policy tool.

Restraining The Economy

All three tools, used separately or together, decrease the amount of money in circulation and raise interest rates. This combination of less money and higher interest rates constrains the economy by inducing fewer expenditures on aggregate production, especially consumption expenditures and investment expenditures. With less aggregate production, fewer resources are used, employment is lower, and unemployment rises. However, most important, there is less pressure and prices, so inflation declines.

This is precisely the stimulation needed of the economy is in a business-cycle expansion that has overheated to the point of causing higher inflation rates. It is also recommended if the economy appears to be headed toward an increase in inflation. In fact, because monetary policy does not affect the economy immediately, implementing contractionary monetary policy before inflation sets it is the preferred strategy. In this way the inflation is not just "fixed," but avoided completely.

Other Policy Options

Contractionary monetary policy is one of several stabilization policies available to the federal government to address business-cycle problems. Congress and the President can also get into the act of restraining the economy through contractionary fiscal policy. Or the Federal Reserve can direct actions toward the unemployment problems through expansionary monetary policy.
  • Contractionary Fiscal Policy: An alternative means of restraining the economy is contractionary fiscal policy. This includes a decrease in government spending and/or an increase in taxes. Both actions decrease aggregate expenditures, aggregate production, employment, and reduce inflationary pressures. Contractionary fiscal policy can be used to complement contractionary monetary policy or as an alternative.

  • Expansionary Monetary Policy: Monetary policy can also be used to address unemployment problems created by a business-cycle contraction. Expansionary monetary policy is the opposite of contractionary monetary policy. It consists of buying U.S. Treasury securities through open market operations, lowering the discount rate, and decreasing reserve requirements. The resulting increase in the money supply and decrease in interest rates increases aggregate expenditures, aggregate production, employment, and thus reduces unemployment.


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CONTRACTIONARY MONETARY POLICY, AmosWEB Encyclonomic WEB*pedia,, AmosWEB LLC, 2000-2024. [Accessed: June 24, 2024].

Check Out These Related Terms...

     | monetary economics | monetary policy | expansionary monetary policy | open market operations | discount rate | reserve requirements | central bank | Federal Reserve pyramid | Board of Governors, Federal Reserve System | Chairman of the Board of Governors, Federal Reserve System | Federal Reserve Banks | Federal Open Market Committee | Federal Advisory Council |

Or For A Little Background...

     | fractional-reserve banking | banks | money | bank reserves | bank panic | business cycles | check clearing | money creation | macroeconomics | monetary base | monetary aggregates | unemployment | inflation | investment expenditures | consumption expenditures | macroeconomic goals | political views |

And For Further Study...

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     | Federal Reserve System |

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