Contraction policies are often linked to monetary policy, with central banks such as the Federal Reserve being able to implement this policy by raising interest rates. Although the initial effect of contraction policies is to reduce nominal gross domestic product (GDP), which is defined as gross domestic product (GDP) valued at current market prices, this often ultimately leads to sustainable economic growth and smoother business cycles. Contraction policy is a monetary measure that refers either to a reduction in public spending – especially deficit spending – or to a reduction in the rate of monetary expansion by a central bank. It is a kind of macroeconomic tool to combat rising inflation or other economic distortions caused by central banks or government intervention. The policy of contraction is the exact opposite of expansive politics. In the United States, a policy of contraction is usually pursued by raising the target federal funds rate, that is, the interest rate that banks charge each other overnight to meet their reserve requirements. Restrictive monetary policy is driven by increases in the various policy rates controlled by modern central banks, or by other means that lead to the growth of the money supply. The goal is to reduce inflation by limiting the amount of active money circulating in the economy. It also aims to suppress unsustainable speculation and capital investment that may have triggered previous expansionary measures. Governments pursue restrictive fiscal policies by raising taxes or cutting public spending. In its crudest form, this policy sucks money from the private sector in the hope of slowing down unsustainable output or driving down asset prices. Nowadays, increasing the level of taxation is rarely seen as a viable contraction measure. Instead, most restrictive fiscal measures end the previous fiscal expansion by cutting public spending – and even then only in target sectors.
The policy of contraction occurred especially in the early 1980s, when then-Federal Reserve Chairman Paul Volcker finally halted the rise in inflation of the 1970s. At their peak in 1981, target federal funds interest rates were approaching 20%. Measured inflation rose from almost 14% in 1980 to 3.2% in 1983. A concrete example of a policy of contraction at work can only be found in 2018. As reported by the Dhaka Tribune, the Bangladesh Bank has announced its intention to issue a contractionary monetary policy to control the supply of credit and inflation and, ultimately, maintain economic stability in the country. When the economic situation changed in the following years, the Bank switched to an expansionary monetary policy. If the policy of contraction reduces the degree of displacement in private markets, it can have a stimulating effect by allowing the private or non-governmental part of the economy to grow. This was true during the forgotten depression of 1920-1921 and in the period immediately after the end of World War II, when leaps in economic growth followed massive cuts in public spending and rising interest rates. The policy of contraction aims to prevent possible distortions of capital markets. Distortions include high inflation due to an expanding money supply, inappropriate asset prices or crowding-out effects, when a rise in interest rates leads to a reduction in private investment spending, slowing down the initial increase in total investment spending.
Federal Reserve Bank of St. Louis. « Inflation, Consumer Prices for the United States »accessed September 4, 2020. « Monetary policy of contraction in sight. » Retrieved 4 September 2020. The Fed can also increase reserve requirements for member banks to reduce the money supply or conduct open market operations by selling assets such as U.S. Treasuries to large investors. This large number of sales lowers the market price of these assets and increases their returns, making them more economical for savers and bondholders. James Chen, CMT, is an experienced trader, investment advisor and global market strategist.
He is the author of books on technical analysis and forex trading published by John Wiley and Sons, and has been a guest expert at CNBC, BloombergTV, Forbes and Reuters, among others. Bangladesh Bank. « Monetary Policy Statements. » Accessed September 4, 2020. History of the Federal Reserve. « Volcker`s announcement of anti-inflation measures. » (accessed September 4, 2020). .