Definition: Restrictive monetary policy is how the Federal Reserve slows down economic growth. The Fed restricts the money supply, which reduces liquidity, and lessens the amount of money and credit that banks can lend. The Fed does this by raising the fed funds rate, which 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 end of each day, 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 its neighbor bank, which might not 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.
Also Known As: contractionary monetary policy
