What Is a Contractionary Policy?

What Is a Contractionary Policy?

Let me explain what a contractionary policy really is. It's a macroeconomic strategy that a central bank uses to cut back on government spending or slow down the rate of monetary expansion. You see this as a direct tool to fight rising inflation.

In the United States, the government applies main contractionary policies like raising interest rates, boosting bank reserve requirements, and selling government securities. These steps help rein in an overheating economy.

Key Takeaways

Contractionary policies serve as macroeconomic tools to address distortions from an overheating economy. They work by slowing the rate of monetary expansion and limiting money flow. Typically, you encounter these policies during periods of high inflation or after excessive speculation driven by earlier expansionary measures.

Understanding Contractionary Policies

These policies aim to prevent distortions in capital markets, such as high inflation from an expanding money supply, inflated asset prices, or crowding-out effects where rising interest rates cut into private investment and dampen overall spending growth.

Initially, a contractionary policy reduces nominal GDP, which is GDP at current market prices, but it often leads to sustainable economic growth and steadier business cycles over time.

A notable example happened in the early 1980s under Federal Reserve chair Paul Volcker, who ended the 1970s inflation surge. Federal funds rates peaked near 20% in 1981, dropping inflation from almost 14% in 1980 to 3.2% by 1983.

Tools Used for Contractionary Policies

Both monetary and fiscal policies deploy strategies to tackle inflation and contract economic growth.

Monetary Policy

Raising interest rates cuts inflation by restricting circulating money and curbs unsustainable speculation or investment sparked by prior expansionary policies. Increasing bank reserve requirements reduces funds available for loans to businesses and consumers. Through open-market operations, selling assets like U.S. Treasury notes lowers their market prices and raises yields.

Fiscal Policy

Raising taxes shrinks the money supply, lowers consumer purchasing power, and can slow unsustainable production or deflate asset values. Cutting government spending in areas like subsidies, welfare, public works contracts, or employee numbers achieves similar contraction.

Real-World Example

The COVID-19 pandemic disrupted production and consumption, prompting governments to use large fiscal stimuli that boosted demand but caused supply chain issues and price pressures. This support led to a strong rebound in GDP and employment through 2021.

By 2022, with inflation rising, the Federal Reserve raised the federal funds rate target to achieve maximum employment and 2% long-term inflation. They see continued rate hikes as necessary to restrict policy enough to bring inflation back to 2%.

Contractionary Policy vs. Expansionary Policy

A contractionary policy slows the economy by reducing money supply and warding off inflation. In contrast, an expansionary policy stimulates the economy by increasing demand via monetary and fiscal measures, aiming to prevent or ease downturns and recessions.

What Are the Effects of Contractionary Policy?

These policies often tighten credit with higher interest rates, raise unemployment, cut business investment, and reduce consumer spending, leading to an overall drop in GDP.

What Is the Main Goal of Contractionary Policy?

The goal is to slow growth to a healthy 2% to 3% annual GDP rate, as faster growth brings negatives like inflation.

Why Is Contractionary Policy Unpopular?

It requires officials to raise taxes and cut spending on programs like social welfare, which voters dislike.

The Bottom Line

Contractionary policy reduces government spending or monetary expansion to combat inflation. Key U.S. methods include higher interest rates, increased reserves, and securities sales. Implementation can be tough, involving tax hikes, unemployment rises, and cuts to programs and subsidies.