Contractionary Policies – Monetary Policy

The implementation of contractionary monetary policies is when the government seeks to increase interest rates to slow the growth of the money supply and reduce inflation, in order to slow economic growth, to keep inflation stable. 

A rise in inflation is usually the primary indicator of an overheated economy, which can be the result of an extended period of strong economic growth. Contractionary policies seek to prevent excessive speculation and capital investment. 

There are three contractionary monetary policy tools that a government usually implements. They are the same tools used in expansionary policies, but the opposite. 

The first is to increase interest rates, which is usually the primary monetary policy tool of a central bank such as the RBA. This is done to reduce the money supply, as the RBA can increase the cost of short-term debt through the provision of an increased short term interest rate. Additionally, consumers and corporations within the economy will also raise interest rates they charge, thus reducing the amount of borrowing and spending. 

The second policy tool that can be implemented is the raising of reverse requirements. As commercial banks are required to hold a certain minimum amount of reserves with the RBA, the RBA can raise the required amount in reserve in order to decrease the amount of money that commercial banks can supply in the economy.

Lastly, a central bank such as the RBA can sell securities, i.e. expand the open market operations. Here, they would sell government-issued securities. Investors would then purchase these government securities from the central bank, reducing the money supply in the economy.