Contractionary monetary policy is the set of policies conducted by central banks aiming to curb inflation and slow overheated economic growth. Through its instruments, the central bank tries to halt the overall rise of prices in the economy and decrease the supply of money. It restricts or tightens the access to money, making it too expensive to borrow, while savings become more attractive.
Usually, the central bank increases the interest rate it charges commercial banks to hold their reserves. Thus, in order to compensate, banks increase the active interest rates they charge to borrowers. Companies and the retail sector borrow less, they reduce spending which reduces demand and thus prices. The effect of increased interest rates is not immediate. It affects the economy through the transmission mechanism showed below.
Thus, higher interest rates reduce aggregate demand. Borrowing becomes more expensive and saving becomes more attractive. Disposable income decreases and spending reduces. It’s worth mentioning, the currency becomes more attractive. Exchange rate appreciates and import becomes cheaper.
Participating in an open market the central bank can also affect the money supply. Namely, by selling bonds it reduces the money available in the market. Less used is the possibility of increasing reserve requirements in order to reduce the amount of money available to the market. The tightening monetary policy is conducted when inflation overrides the target which is usually set at 2%.
One of the examples of restrictive monetary policy is the one during inflation in the US in 1973. Policymakers increased interest rates and slowed economic growth, however, the inflation persisted causing the phenomenon called stagflation. Being politically pressured, Fed lowered interest rates and inflation further raised by 1975. When Paul Volcker became the chair, he increased fed fund rate to 20% in 1979 and curbed inflation.
Earlier, the Fed had conducted contractionary monetary policies to deal with the hyperinflation of the late 1920s. However, it caused the recession and the stock market crashed in 1929. Instead of switching to the opposite, expansionary policy, it kept rising rates causing decade long depression.
In 1920s UK also suffered from depression. The BOE raised its discount rate firstly from 5 to 6 percent in November 1919 and then to 7 percent in April 1920. Higher interest rates reduced investment and spending. It also increased the cost of servicing Britain’s debt. Keynes argued that Pound was overvalued as much as 10% against the Dollar. The reason behind were efforts to keep Britain in the Gold Standard. UK exports were overvalued, and monetary policy had to be kept tighter than necessary.