Contractionary Monetary Policy

Contractionary monetary policy (Dear Money Policy/Tight Monetary Policy) is a type of monetary policy used by a central bank to control inflation by reducing the money supply, raising interest rates and moderating aggregate demand.

Objectives

• Control Inflation: Reduce excessive aggregate demand to moderate the rise in the general price level.
• Reduce Excessive Consumption: Higher borrowing costs make loans more expensive, discouraging excessive consumer spending.
• Moderate Investment: Higher interest rates increase the cost of borrowing for businesses, reducing excessive investment and expansion.
• Control Excessive Credit Growth: Tighter monetary conditions make borrowing more expensive and restrict excessive expansion of credit.
• Maintain Price Stability: By moderating demand and inflationary pressures, contractionary monetary policy helps maintain stability in the general price level.

Instruments of Contractionary Monetary Policy

1. Increase in Policy Interest Rate

• The central bank raises its policy interest rate, making borrowing more expensive and discouraging consumption and investment.
• India → RBI increases the Policy Repo Rate
  • Repo Rate ↑ → Lending Rates tend to ↑ → Borrowing ↓ → Consumption & Investment ↓ → Aggregate Demand ↓ → Inflationary Pressure ↓

2. Increase in Bank Reserve Requirements

• The central bank can increase the reserve requirements imposed on banks, leaving them with fewer funds available for lending and credit creation.
  • Reserve Requirements ↑ → Funds Available with Banks ↓ → Lending Capacity ↓ → Credit Creation ↓
• India → RBI increases the Cash Reserve Ratio (CRR)
  • CRR ↑ → Cash Reserves with RBI ↑ → Funds Available with Banks ↓ → Lending Capacity ↓ → Credit Creation ↓

3. Open Market Sale of Government Securities

• The central bank can sell government securities in the open market, thereby absorbing liquidity from the financial system.
  • Central Bank Sells Government Securities → Buyers Pay Central Bank → Liquidity in Financial System ↓
• India → RBI sells Government Securities through Open Market Operations (OMOs)
  • RBI Sells G-Secs → Liquidity Absorbed from Banking System → Availability of Funds ↓

Direction of Monetary Policy Instruments

During monetary tightening, the following changes generally have a contractionary effect:

• Repo Rate ↑ → Borrowing from RBI becomes costlier → Credit conditions tighten
• Bank Rate ↑ → Borrowing from RBI becomes costlier
• MSF Rate ↑ → Overnight borrowing from RBI under MSF becomes costlier
• SDF Rate ↑ → Return on funds parked with RBI ↑ → Parking surplus funds with RBI becomes relatively more attractive
• CRR ↑ → Banks maintain more cash with RBI → Funds available for lending ↓
• SLR ↑ → Larger proportion of deposits required to be maintained in specified liquid assets → Funds potentially available for lending ↓
• Reverse Repo Rate ↑ → Return on funds parked with RBI under reverse repo ↑ → Parking surplus funds with RBI becomes relatively more attractive
• OMO Sale of Government Securities → RBI sells G-Secs → Liquidity absorbed from the banking system

Impact on the Economy

• Inflation: Lower aggregate demand helps moderate demand-side inflationary pressures.
• Consumption: Higher borrowing costs discourage household expenditure, particularly credit-financed purchases.
• Investment: Higher interest rates make business loans more expensive, tending to reduce investment.
• Credit Growth: Tighter monetary conditions reduce demand for and availability of credit.
• Economic Growth: Lower consumption and investment moderate aggregate demand and can slow economic activity.
• Employment: Slower demand and production can weaken the growth of employment.

Expansionary vs Contractionary Monetary Policy