Contractionary monetary policy refers to a mechanism of controlling a nation’s economy to keep relatively slow growth rates. For instance, a central bank can raise interest rates for commercial banks as a way to decrease the amount of money in circulation. The reduced money supply would then cause inflation rates to either decrease or remain stable.
For instance, a central bank or the Federal Reserve may implement contractionary monetary policy by selling government bonds and treasury notes to commercial banks. In the end, commercial banks have a reduced amount of available money to lend, and thus, they increase interest rates. Even though the contractionary monetary policy slows inflation, it may impair economic growth by reducing consumption and investment rates.
On the other hand, expansionary monetary policy is a macroeconomic strategy that intends to stimulate the economy by increasing the money supply. For example, central banks can reduce short-term interest rates, lower reserve requirements, and buy securities. Primarily, an expansionary monetary policy promotes economic growth and decreases unemployment. Also, the policy may benefit the economy through currency devaluation that increases the competitiveness of exports and makes the economy more attractive to foreigners. However, an expansionary monetary policy increases inflation levels.
Reserve requirement or reserve ratio refers to the percentage of total deposits that central banks require commercial banks to hold as cash. The reserve requirement ensures that commercial banks have cash on hand to meet withdrawals. If the central bank intends to increase the amount of money in circulation, it reduces the reserve ratio to increase the amount of money that commercial banks can lend. In contrast, the central bank increases banks’ ratios if it needs to reduce the money supply.
Essentially, Central Banks (such as the Federal Reserve) use monetary policy as a tool to control the ebb and flow of money throughout a country’s economy. Monetary policies are important because they can create booms and busts in the business cycle of an economy.