Definition: Restrictive monetary policy is how the Federal Reserve slows down economic growth. It's called restrictive because the Fed restricts the money supply. This reduces liquidity, which lessens the amount of money and credit that banks can lend.
The Purpose of Restrictive Monetary PolicyThe purpose of restrictive monetary policy is to ward off inflation. If prices are rise about 2% a year, this is actually good for the economy because it stimulates demand. People expect prices to be higher later, so they buy more now. However, if inflation gets much above this level, it can be very damaging. People buy too much now to avoid paying higher prices later. This causes businesses to either produce more, to take advantage of higher demand, or to raise prices further because they can't produce more. They take on more workers, so people have higher incomes, so they spend more. It becomes a vicious cycle. If it goes too far, it can result in hyperinflation, where prices rise 50% a month. (For more, see Types of Inflation.)
To avoid this, the Federal Reserve tries to slow demand by making purchases more expensive. It does this by raising bank lending rates, which makes loans and home mortgages more expensive. This is usually enough to cool inflation, and return the economy to a healthy growth rate of 2-3%.
Exactly How Does the Fed Implement Restrictive Monetary Policy?
The Fed has a lot of tools it can use to restrict the money supply. Its first course of action is to raise the Fed funds rate. This is the rate banks charge each other for overnight deposits. The Fed mandates that banks must keep a certain amount of cash, or reserve requirement, on deposit at their local Federal Reserve branch office at all times. At the close of business, a bank might have a bit more than it needs to meet the reserve requirement. If so, it will lend it, charging the Fed funds rate, to another bank that doesn't have quite enough. A higher Fed funds rate makes it more expensive for banks to keep their mandated reserve, and this restricts the monetary supply. This tiny bit is enough to slow the economy, when needed.
Another tool the Fed uses to implement restrictive monetary policy is open market operations. The Federal Reserve is the central bank for the Federal government, including the U.S. Treasury. When the government has more cash than it needs at the moment, it will deposit Treasury notes at the central bank. When the Fed wants to reduce the money supply, it sells these Treasuries to its member banks. The banks pay for the securities with some of the cash they have on hand to meet their reserve requirement. Holding Treasuries mean they now have less cash to lend.
The opposite of restrictive open market operations is called quantititative easing. That's when the Fed buys Treasuries, mortgage-backed securities or any other type of bond or loan. This is expansionary policy because the Fed simply creates the credit out of thin air to purchase these loans. This is just like the Fed printing money.
The Fed could also raise the discount rate. That's what it charges banks who borrow funds from the Fed's discount window. Banks rarely use the discount window,even though the rates are usually lower than the Fed funds rate. That's because other banks assume the bank must be weak if it's forced to use the discount window. In other words, it couldn't get loans from other banks to meet the reserve requirement.
The Fed usually does raise the discount rate when it raises the target for the Fed funds rate. However, it's really not an effective tool of restrictive monetary policy, because banks rarely use it.
The least likely thing the Fed would do is raise the reserve requirement. This would immediately reduce the money banks could lend. However, it would also require the banks to develop new policies and procedures. It would have no advantage over raising the Fed funds rate, which is just as effective. (Source: The Federal Reserve Bank of San Francisco, Federal Reserve Tools)
Also Known As: contractionary monetary policy