Definition
The term contractionary monetary policy refers to the process by which the central bank decreases the money supply to slow down economic growth. Contractionary policy is typically used to prevent and / or reduce inflation.
Explanation
Contractionary monetary policy refers to a process whereby a country's central bank attempts to slow down the growth of their economy, which is resulting in a higher than desired level of inflation. The principal tools of a contractionary policy in the United States include:
Money Supply: decreasing the money supply through open market operations, whereby the central bank sells Treasury notes to member banks thereby decreasing the supply of money.
Federal Funds: the federal funds rate is the interest rate charged banks for overnight deposits. Increasing the fed funds rate makes it more expensive for banks to borrow from other banks to maintain their reserve requirement, thereby discouraging additional lending by increasing the interest rates charged their customers.
Discount Rate: the central bank can also increase what's referred to as the discount rate. The discount rate is oftentimes increased when the Federal Funds rate is increased. Banks will only borrow from the central bank when no other lending institution will provide them funds.
All three of the above tactics discourage spending, thereby slowing down the growth of an economy. When a contractionary monetary policy is in place, the central bank must ensure the economy doesn't slow down too rapidly, resulting in a recession.
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