What Is a Contractionary Policy?
Contractionary policy is a type of monetary measure that can be used to cut back on government spending, especially deficit spending. It can also be used by a central bank to slow down the growth of the money supply. It is a type of macroeconomic tool that is used to fight rising inflation or other economic problems caused by central banks or government actions. Contractionary policy is the opposite of expansionary policy in every way.
Because of the state of the country’s economy, a government may choose to use fiscal policy or not. This decision is based on how to balance the country’s economy. Expansionary policy is used when the economy is in a downturn. In order to boost GDP, the government lowers taxes and increases government spending and transfer payments.
Overheating the economy, on the other hand, is bad because it leads to high inflation. In this case, a contractionary policy is used to cut government spending and raise taxes. As a result, there is a budget surplus, which is taken out of circulation or used to pay off debts from other countries. There are more people out of work and less production, which slows down the economy. In both ways, fiscal policy can be contractionary or expansionary. There are some downsides to both. It can not only slow down the economy, but it can also lead to a recession or a change in the way things work.
A Granular View of Contractionary Policy
Contractionary policies are meant to keep the capital markets from being distorted. Among the distortions are high inflation from an expanding money supply, unrealistic asset prices, or crowding-out effects, where a rise in interest rates causes a drop in private investment spending so that it dampens the initial rise in total investment spending, as shown in this graph.
While the first effect of the contractionary policy is to lower nominal gross domestic product (GDP), which is the gross domestic product (GDP) evaluated at current market prices, it often leads to long-term growth and smoother business cycles.
In the early 1980s, when then-Federal Reserve chair Paul Volcker was finally able to stop the high inflation of the 1970s, he used a policy called “contractionary policy.” A target federal fund interest rate of 20% was reached in 1981, when the rate was at its highest point. In 1980, inflation was measured at almost 14%. In 1983, it was only 3%.
Contractionary Policy as Fiscal Policy
Governments use contractionary fiscal policy when they raise taxes or cut government spending. When these policies are in their most basic form, they take money from the private economy in the hope that it will slow down unsustainable production or lower the value of assets. There are very few people who think that raising taxes is an option that will help the economy get back on track in the present day. Instead, most fiscal policies that are “contractionary” try to reverse the effects of fiscal expansion by cutting back on government spending, but only in certain areas.
The private markets may not be crowded out as much if the government cuts back on its spending. This could have a positive effect on the private or non-government part of the economy. After World War II came to an end, there was a big drop in government spending and a rise in interest rates. This happened both during the Forgotten Depression of 1920 to 1921 and right after.
Contractionary Policy as a Monetary Policy
When modern central banks raise the base interest rates they set, they’re making the money supply grow. This is called “contractionary monetary policy.” The goal is to keep inflation down by limiting the amount of money that is available to buy things in the economy. It also tries to stop unsustainable speculation and investment that may have been caused by previous policies that were too big.
US: A contractionary policy is usually done by raising the target federal funds rate, which is the interest rate banks charge each other overnight in order to meet their reserve needs.
Members of the Federal Reserve may also have to keep more money in reserve. This could be done to reduce the money supply or to sell assets like U.S. Treasuries to big investors. For savers and bond holders, this means that the price of these assets drops and the rate of return goes up, which makes them more affordable.
Contractionary Policy Example
A contractionary policy in action can be seen right now, so look no further than the year 2018. Bangladesh’s central bank, the Bangladesh Bank, has said that it will try to control the amount of credit and inflation in order to keep the country’s economy stable. As the economy changed in later years, the bank changed its monetary policy to one that was more focused on growth.