What Is Contractionary Policy? Definition, Purpose, and Example

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What Is a Contractionary Policy?

A contractionary policy is a monetary measure to reduce government spending or the rate of monetary expansion by a central bank. It is a macroeconomic tool used to combat rising inflation.

The main contractionary policies employed by the United States government include raising interest rates, increasing bank reserve requirements, and selling government securities.

Key Takeaways

• Contractionary policies are macroeconomic tools designed to combat economic distortions caused by an overheating economy.
• Contractionary policies aim to reduce the rates of monetary expansion by putting some limits on the flow of money in the economy.
• Contractionary policies are typically issued during times of extreme inflation or when there has been a period of increased speculation and capital investment fueled by prior expansionary policies.

Understanding Contractionary Policies

Contractionary policies aim to hinder potential distortions to the capital markets. Distortions include high inflation from an expanding money supply, unreasonable asset prices, or crowding-out effects, where a spike in interest rates leads to a reduction in private investment spending such that it dampens the initial increase of total investment spending.

While the initial effect of the contractionary policy is to reduce nominal gross domestic product (GDP), which is defined as the gross domestic product (GDP) evaluated at current market prices, it often ultimately results in sustainable economic growth and smoother business cycles.

Contractionary policy notably occurred in the early 1980s when the then-Federal Reserve chair Paul Volcker finally ended the soaring inflation of the 1970s. At their peak in 1981, target federal fund interest rates neared 20%. Measured inflation levels declined from nearly 14% in 1980 to 3.2% in 1983.

Tools Used for Contractionary Policies

Both monetary and fiscal policies implement strategies to combat rising inflation and help to contract economic growth.

Monetary Policy

• Increasing interest rates reduces inflation by limiting the amount of active money circulating in the economy. This also quells unsustainable speculation and capital investment that previous expansionary policies may have triggered.
• Increasing bank reserve requirements, the level of required reserves held by banks effectively decreases the funds available for lending to businesses and consumers.
• Selling assets like U.S. Treasury notes, the Federal Reserve uses open-market operations as a tool. These sales lower the market price of such assets and increase their yields.

Contractionary policy is often connected to monetary policy, with central banks such as the U.S. Federal Reserve, able to enact the policy by raising interest rates.

Fiscal Policy

• Increasing taxes reduces the money supply and decreases the purchasing power of consumers. It may also slow down unsustainable production or lower the value of assets.
• Reducing government spending in areas such as subsidies, welfare programs, contracts for public works, or the number of government employees.
  

Real-World Example

The COVID-19 pandemic affected businesses' ability to produce and consumers' ability to consume. Many governments resorted to large fiscal stimuli which boosted consumption leading to supply chain bottlenecks and price tensions.

The government support throughout the crisis supported a strong economic rebound, with both GDP and employment recovering at a remarkable pace through 2021.

However, in 2022, with growing signs of inflation, and to achieve maximum employment and keep the inflation at the rate of 2 percent over the long run, the Federal Reserve decided to raise the target range for the federal funds rate.

The Fed views ongoing increases in the target range as appropriate to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.

Contractionary Policy vs. Expansionary Policy

A contractionary policy attempts to slow the economy by reducing the money supply and fending off inflation.

An expansionary policy is an effort that central banks use to stimulate an economy by boosting demand through monetary and fiscal stimulus. Expansionary policy is intended to prevent or moderate economic downturns and recessions.

What Are the Effects of Contractionary Policy?

A contractionary policy often results in the tightening of credit through increased interest rates, increased unemployment, reduced business investment, and reduced consumer spending. There is commonly an overall reduction in the gross domestic product (GDP).

What Is the Main Goal of Contractionary Policy?

The purpose of a contractionary policy is to slow growth to a healthy economic level, typically between 2% to 3% a year for the GDP. An economy that grows more than 3% creates negative consequences, including inflation.

Why Is Contractionary Policy Unpopular?

Contractionary policies require elected officials to increase taxes and reduce government spending, like social and welfare programs, both unpopular with voters.

The Bottom Line

A contractionary policy is a tool used to reduce government spending or the rate of monetary expansion by a central bank to combat rising inflation. The main contractionary policies employed by the United States include raising interest rates, increasing bank reserve requirements, and selling government securities. Contractionary policies are often difficult to implement as they may also include increases in tax rates, higher rates of unemployment, and a decrease in government programs and subsidies.

1. Federal Reserve History. "Volcker's Announcement of Anti-Inflation Measures."
2. Federal Reserve Bank of St. Louis. "Inflation, Consumer Prices for the U.S."
3. U.S. Federal Reserve Board. "Fiscal Policy and Excessive Inflation During COVID-19: a Cross Country View."
4. U.S. Federal Reserve Board. "Federal Reserve Issues FOMC Statement."

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