Contractionary Policy

A contractionary policy is a monetary measure to reduce government spending or the rate of monetary expansion by a central bank. It is a macroeconomic tool used to combat rising inflation.

The main contractionary policies employed by the United States government include raising interest rates, increasing bank reserve requirements, and selling government securities.

Contractionary policies aim to hinder potential distortions to the capital markets. Distortions include high inflation from an expanding money supply, unreasonable asset prices, or crowding-out effects, where a spike in interest rates leads to a reduction in private investment spending such that it dampens the initial increase of total investment spending.

While the initial effect of the contractionary policy is to reduce nominal gross domestic product (GDP), which is defined as the gross domestic product (GDP) evaluated at current market prices, it often ultimately results in sustainable economic growth and smoother business cycles.

The COVID-19 pandemic affected businesses’ ability to produce and consumers’ ability to consume. Many governments resorted to large fiscal stimuli which boosted consumption leading to supply chain bottlenecks and price tensions.

The government support throughout the crisis supported a strong economic rebound, with both GDP and employment recovering at a remarkable pace through 2021.

However, in 2022, with growing signs of inflation, and to achieve maximum employment and keep the inflation at the rate of 2 percent over the long run, the Federal Reserve decided to raise the target range for the federal funds rate.

The Fed views ongoing increases in the target range as appropriate to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.

A contractionary policy attempts to slow the economy by reducing the money supply and fending off inflation.

An expansionary policy is an effort that central banks use to stimulate an economy by boosting demand through monetary and fiscal stimulus. Expansionary policy is intended to prevent or moderate economic downturns and recessions. A contractionary policy often results in the tightening of credit through increased interest rates, increased unemployment, reduced business investment, and reduced consumer spending. There is commonly an overall reduction in the gross domestic product (GDP). Contractionary policies require elected officials to increase taxes and reduce government spending, like social and welfare programs, both unpopular with voters.

A contractionary policy is a tool used to reduce government spending or the rate of monetary expansion by a central bank to combat rising inflation. The main contractionary policies employed by the United States include raising interest rates, increasing bank reserve requirements, and selling government securities.

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