What is Contractionary Monetary Policy?
Contractionary monetary policy[1] is the process whereby a central bank deploys various tools to lower inflation and the general level of economic activity. Central banks do so through a combination of interest rate hikes, raising the reserve requirements for commercial banks and by reducing the supply of money through large-scale government bond sales, also known as, quantitative tightening (QT).
It may seem counter-intuitive to want to lower the level of economic activity but an economy operating above a sustainable rate produces unwanted effects like inflation[2] – the general rise in the price of typical goods and services purchased by households.
Therefore, central bankers employ a number of monetary tools to intentionally lower the level of economic activity without sending the economy into a tailspin. This delicate balancing act is often referred to as a ‘soft landing’ as officials purposely alter financial conditions, forcing individuals and businesses to think more carefully about current and future purchasing behaviors.
Contractionary monetary policy often follows from a period of supportive or ‘accommodative monetary policy’ (see quantitative easing[3]) where central banks ease economic conditions by lowering the cost of borrowing by lowering the country’s benchmark interest rate; and by increasing the supply of money in the economy via mass bond sales. When interest rates are near zero, the cost of borrowing money is almost free which stimulates investment and general spending in an economy after a recession.
Contractionary Monetary Policy Tools
Central banks make use of raising the benchmark interest rate, raising the reserve requirements for commercial banks, and mass bond sales. Each is explored below:
1) Raising the Benchmark Interest Rate
The benchmark or base interest rate refers to the interest rate that a central bank charges commercial
