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

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

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

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

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 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.