The contractionary monetary policy is the opposite of the expansionary monetary policy. It is used to fight inflation which involves decreasing the money supply to increase the cost of borrowing which in turn decreases GDP and dampens inflation.
Once the Central Bank of the country (In India RBI) puts too much liquidity into the banking system, it risks triggering inflation. To contain the inflation the Central Bank places on brakes by implementing the following contractionary or restrictive monetary policy. It’s also called a restrictive monetary policy because it restricts liquidity in the economy. The contractionary monetary policy decreases the money supply, increases interest rates, and decreases aggregate demand. It knocks down growth as measured by gross domestic product. It also increases the currency’s value, thereby increasing the exchange rate.
As a first step, the central bank focuses on decreasing the money supply by inflating key policy rates like repo rate, reverse repo rate, bank rate, etc., or selling government securities through open market operation or by carrying out all the changes simultaneously. Further, the Central Bank seeks to encourage banks to decrease lending. It stipulates the higher cash reserve ratio, and or higher statutory liquidity ratio which is essentially the amount of capital a bank needs to hold onto when making loans. As a result, banks have less money available to lend. With less money to lend, they charge a higher interest rate.
The direct effect of an increase in interest rates is that it increases borrowing costs. An increase in borrowing costs discourages corporates from lending for business expansion. It dampens individual borrowers from going for home or auto loans or using credit cards at a prohibitive borrowing cost. On the other hand, the higher interest rate makes government bonds, and bank deposits more attractive. It offers people an opportunity to add savings rather than spending more on consumption and investing in other riskier portfolios.
Bottom-line:
The contractionary monetary policy deters the expansionary phase of the business cycle. The main problem of contractionary monetary policy is the outcome, an increase in the unemployment rate and a decrease in the GDP growth rate.
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