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Contractionary Monetary Policy

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contractionary monetary policy

Federal Reserve Chairman Ben Bernanke wisely did not use contractionary monetary policy to combat the 2008 financial crisis.

(Photo:Win McNamee/Getty Images)
Definition: Contractionary monetary policy is when the Federal Reserve uses the Federal funds rate and its other tools to slow economic growth. The Fed's goal is to do this without pushing the economy into a recession. Therefore, the Fed would only do implement contractionary policy to fulfill its primary mandate of preventing inflation. Contractionary monetary policy probably wouldn't be used unless the core inflation rate is more than the Federal Reserve's 2% target inflation rate. Core inflation is the year-over-year price increases for everything measured by the Consumer Price Index except volatile food and oil prices.)

How Contractionary Monetary Policy Is Implemented

The Fed's first line of defense is raising the target for the Fed funds rate. This increases the rate that banks charge each other to borrow funds to meet the Federal Reserve requirement. This requirement is the amount the Federal Reserve requires banks have on deposit each night when they close their books. This amount is usually 10% of their total deposits. Without this requirement, banks would lend out single every dollar they get in. This means they wouldn't have enough cash to cover operating expenses if any of the loans defaulted.

Raising the Fed funds rate is contractionary because it decreases the money supply. That's because banks charge higher interest rates on their loans to compensate for the higher Fed funds rate. Businesses borrow less, don't expand as much, and hire fewer workers, decreasing demand. They are also less likely to raise prices, putting an end to inflation.

The Fed could also simply raise the Reserve requirement, which is also contractionary monetary policy. However, the Fed does this rarely. That's because it's very disruptive to banks to institute a lot of new procedures and regulations to insure the new Reserve requirement is met. Raising the Fed funds rate is easier, and meets the same objective.

The third tool the Fed uses in contractionary monetary policy is open market operations. That's when the Fed buys or sells its holdings of U.S. Treasury notes. To implement contractionary monetary policy, the Fed sells Treasuries to one of its member banks. The bank pays for the securities by adding to its reserves. This reduces the money it has available to lend, so it will charge a higher interest rate.The Fed did the opposite of this, using expansionary monetary policy, when it launched quantititative easing. (Source: The Federal Reserve Bank of San Francisco, Federal Reserve Tools)

Examples of Contractionary Monetary Policy

There aren't many examples of contractionary monetary policy for two reasons. First, Fed Chairman usually want the economy to grow, not shrink. More important, inflation hasn't really been a problem since the 1970s. Inflation was caused by It is the antidote to the stop-go monetary policy of the past. For example, in 1973 inflation went from 3.9% to 9.6%. The Fed raised interest rates, from 5.75%, to 13% by July 1974. Despite inflation, economic growth was slow, a situation known as stagflation.

The Fed backed down, responding to political pressure and dropped the rate to 7.5% in January 1975. Inflation responded to this stop-go monetary policy by remaining stubbornly stuck at the 10-12% range through April 1975. Instead of maintaining its contractionary monetary policy, the Fed confused businesses, who were afraid to lower prices when interest rate went down because they weren't sure the Fed wouldn't just turn around and raise rates again. When Paul Volcker became Fed Chair in 1979, he raised the Fed funds rate to 20% and kept it there, finally putting the stake through the heart of inflation.

Federal Reserve Chairman Ben Bernanke said that contractionary monetary policy helped cause the Great Depression. The Fed correctly instituted contractionary monetary policies to curb the hyperinflation of the late 1920s. However, the Fed didn't lower rates during the recession or stock market crash of 1929. The Fed kept raising rates to protect the dollar's value after investors created a bubble in the currency markets. At that time, dollars were still on the gold standard, and the Fed didn't want speculators to sell their dollars for gold and deplete the reserves at Fort Knox. Instead of an expansionary monetary policy that would have created a little healthy inflation, the Fed protected the dollar's value and created massive deflation. This helped worsen a recession into a decade-long depression. Article updated March 19, 2013

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