Page 207 - A Canuck's Guide to Financial Literacy 2020

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Contractionary Monetary Policy

When the government is looking to cool down an overheating economy, they will embrace a
contractionary monetary policy. This type of policy is intended to lower the money supply in
the economy and fight inflation. A high inflation is an indicator of an economy running at full
capacity. To reduce the inflation, the government would typically increase the interest rates,
raise bank reserve requirements and sell government securities.

1. Increase Interest Rates – The central bank would aim to reduce the money supply
by increasing the interest rates. This would result in less borrowing by consumers as
banks would raise interest rates that they charge to clients.
2. Increase Reserve Requirements – Banks are required to hold a minimum amount of
financial reserves with the central bank. To reduce the money supply, the central bank
would raise the reserve requirements. This would affect the number of loans that
banks can hand out to consumers.
3. Sell Government Securities – The government would reduce the money supply by
selling government bonds to institutional investors. This open market operations
would reduce the amount of money circulating in the economy.

Through a contractionary monetary policy, the government is able to:

▪ Reduce Inflation – Through a tightening monetary policy, the government’s goal is to
reduce inflation and cool down the economy. By reducing the money supply, the
prices of goods and services can be stabilized.
▪ Cool Down Economic Growth – The reduction of money supply cools down the
economy. Consumers and businesses lower their spending and capital investments
which in turn slows down production of goods and services.
▪ Increase Unemployment – The cooling down of the economy comes at an expense
of increased unemployment. As companies slow down their production of goods and
services, this in turns causes a rise in unemployment as less people are spending.
Unemployment and contraction monetary policies are positively correlated.