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What Contractionary Policy Is

What is a contractionary policy?

Contractionary policy is a monetary measure referring either to a reduction in government spending particularly deficit spending or a reduction in the rate of monetary expansion by a central bank. It is a macroeconomic tool that can be used to counter rising inflation and other economic distortions caused by central banks and government intervention. Contractionary policy is the opposite of expansionary.

What is a Contractionary Policy?

Potential distortions in the capital markets can be prevented by constrictive policies. High inflation due to an expanding money supply, unreasonable asset prices, or crowding-out effects are all examples of distortions. A spike in interest rates can lead to a decrease in private investment spending, which dampens the initial rise in total investment spending.

Although the primary effect of the contractionary strategy is to decrease nominal gross domestic products (GDP), it can often lead to sustainable economic growth and better business cycles.

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The 1980s saw the end of high inflation, which was a result of the contractionary policy. Target federal fund interest rates were close to 20% at their highest point in 1981. Inflation levels measured declined from almost 14% in 1980 down to 3.2% by 1983.

Fiscal Policy as Contractionary Policy

Fiscal policy is a contractionary one. This can be done by increasing taxes or decreasing government spending. These policies, in their simplest form, siphon money from private economies with the hopes of slowing unsustainable production and lowering asset prices. Modern times don’t see an increase in tax as a viable contractionary option. Most contractionary fiscal policies, however, unwind fiscal expansion by reducing government spending, and even then only in specific sectors.

Contractionary policies that reduce the number of people in the private market may have a stimulating effect, allowing for the growth of the non-governmental or private sector. This was true in the Forgotten Depression from 1920-1921, and in the period immediately following World War II, when economic growth surged after massive cuts to government spending and higher interest rates.

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The contractionary policy can often be linked to monetary policy. Central banks like the U.S. Federal Reserve are able to enact this policy by raising interest rates.

Contractionary Policy as Monetary Policy

Contractionary monetary policies are driven by changes in the base interest rates, which can be controlled by modern central banks or other means that productivity growth in the money supply. It aims to lower inflation by restricting the flow of active money in the economy. It also seeks to end unsustainable speculation and capital investments that may have been triggered by previous expansionary policies.

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The United States typically performs a contractionary strategy by increasing the target federal funds rates, which is the overnight interest rate banks charge each another, to meet reserve requirements.

In an effort to reduce the money supply and perform open-market operations, the Fed could also increase reserve requirements for member banks. This is done by selling assets such as U.S. Treasuries to large investors. The large volume of these sales reduces the market value of such assets and boosts their yields, making them more affordable for bondholders and savers.

Example of a Contractionary Policy

2018 is a good example of a real contractionary policy in action. According to Dhaka Tribune, the Bangladesh Bank plans to issue a contractionary monetary policy to manage credit supply and inflation, and maintain economic stability. The bank switched to an expansion-oriented monetary policy as the economy changed over the years.

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