Download Monetary Policy and Inflation

Contractionary monetary policy is monetary policy that seeks to reduce the size of the
money supply. In most nations, monetary policy is controlled by either a central bank or a
finance ministry.
Neoclassical and Keynesian economics significantly differ on the effects and
effectiveness of monetary policy on influencing the real economy; there is no clear
consensus on how monetary policy effects real economic variables (aggregate output or
income, employment). Both economic schools accept that monetary policy affects
monetary variables (price levels, interest rates).
Monetary policy relies on a number of tools: monetary base, reserve requirements,
discount window lending and interest rates.
Contents
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1 Policy Tools
o 1.1 Monetary Base
o 1.2 Reserve Requirements
o 1.3 Discount Window Lending
o 1.4 Interest Rates
2 Monetary Policy and Inflation
3 Monetary Policy and the Real Economy
4 See also
[edit] Policy Tools
[edit] Monetary Base
Contractionary policy can be implemented by reducing the size of the monetary base.
This directly reduces the total amount of money circulating in the economy.
A central bank can use open market operations to reduce the monetary base. The central
bank would typically sell bonds in exchange for hard currency. When the central bank
collects this hard currency payment, it removes that amount of currency from the
economy, thus contracting the monetary base.
[edit] Reserve Requirements
The monetary authority exerts regulatory control over banks. Contractionary policy can
be implemented by requiring banks to hold a higher proportion of their total assets in
reserve. Banks only maintain a small portion of their assets as cash available for
immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By
requiring a higher proportion of total assets to be held as liquid cash, a central bank or
finance ministry reduces the availability of loanable funds. This acts as a reduction in the
money supply.
[edit] Discount Window Lending
Many central banks or finance ministries have the authority to lend funds to financial
institutions within their country. By calling in existing loans the central bank can directly
reduce the size of the money supply. By advertising that the discount window will be
reduced for future lending, the central bank can also indirectly reduce the money supply
by reducing risk-taking by financial institutions.
[edit] Interest Rates
The contraction of the monetary supply can be achieved indirectly by increasing the
nominal interest rates.
Monetary authorities in different nations have differing levels of control of economywide interest rates. In the United States, the Federal Reserve can set the federal funds rate
by open market operations. This rate has significant effect on other market interest rates,
but there is no perfect relationship. In the United States open market operations are a
relatively small part of the total volume in the bond market.
In other nations, the monetary authority may be able to mandate specific interest rates on
loans, savings accounts or other financial assets. By raising the interest rate(s) under its
control, a monetary authority can contract the money supply, because higher interest rates
encourage savings and discourage lending. Both of these effects reduce the size of the
money supply.
[edit] Monetary Policy and Inflation
Monetary policy can be used to control inflation. Inflation is defined as continuing
increases in price levels. Since price level is a monetary variable, monetary policy can
affect it. Contractionary monetary policy has the effect of reducing inflation by reducing
upward pressure on price levels.
Note that inflation can also be affected by fiscal policy. However, contractionary fiscal
policy is often politically unpopular, because it involves spending cuts and tax increases.
Thus, politicians favor the use of monetary policy to control inflation.
[edit] Monetary Policy and the Real Economy
As noted above, the relationship between monetary policy and the real economy is
uncertain. It is important to note that contractionary monetary policy should not be
confused with economic contraction (the latter being a reduction in economic output in
the real economy.