Contractionary Monetary Policy
Contractionary monetary policy is defined as macroeconomic tool that is used by the central bank of a country or its finance ministry for purposes of slowing down the economy. This kind of policy is enacted by a government with the aim of reducing the supply of money and ultimately, spending within a country. There are a couple of ways through which this is done and they include the following:
- Increased interest rates
- Increased reserve requirements
- Reduced money supply either indirectly or directly
The policy is used during growth periods of business cycle that are high but he effect is not immediate. Therefore, this means the purpose of the policy is emphasizing on reduction of money supply for less investment and spending thereafter slowing the economy down. The idea is making sure people spend less by making the prospect cost of holding cash high. The policy’s effectiveness varied in accordance to investment and spending patterns in the economy.
The major purpose of this policy is slowing down inflation which accompanies a flourishing economy. The government will apply different techniques to accomplish this and they include, slowing government spending. The interest rates can also be raised making it more costly to borrow money. Inflation is slowed by reigning economic growth and this aids cool the markets off and also decreases overall demand which means the prices also go down.
Inflation leads to ever rising prices and this eventually negatively impact the spending power of the consumer. The fluctuation of prices can leave the consumers erratic and nervous in regard to spending patterns. This policy aids stabilize prices as inflation slows increasing consumer confidence and keeping the economy even while encouraging spending patterns that are stable.
A contractionary monetary policy slows down production. This is a by-product of the country’s economic engine slowing down. The major culprits in this case include r3educed product and service demand as well as costly investment capital. Once production is geared down by companies, it often takes years before it is ramped again. If this policy exceeds the mark and tightens a country’s economy relentlessly than intended, companies slow down production and this in turn shutters plans for expansions. Consequently, this throws the economy into a recession loop.
Contractionary monetary policy can also cause increased rate of unemployment because as companies slow down their growth rate, they are forced to hire less employees. Increased cases of unemployment cost the government increased insurance admin costs as well as social service expenses. Therefore, governments are supposed to weigh the cost of this against economic benefits associated with inflation reduction. High rates of unemployment can reduce consumer confidence as well.
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