What Is the Difference between Expansionary and Contractionary Policy

What Is the Difference between Expansionary and Contractionary Policy

Contraction policies are often linked to monetary policy, with central banks such as the Federal Reserve being able to implement this policy by raising interest rates. A concrete example of a policy of contraction at work can only be found in 2018. As reported by the Dhaka Tribune, the Bangladesh Bank has announced its intention to issue a contractionary monetary policy to control the supply of credit and inflation and, ultimately, maintain economic stability in the country. When the economic situation changed in the following years, the Bank switched to an expansionary monetary policy. In the United States, a policy of contraction is usually implemented by raising the target federal funds rate, which is the interest rate that banks charge each other overnight to meet their reserve requirements. We can compare the discount rate (policy interest rate) with the neutral interest rate. If the discount rate is higher than the neutral interest rate, monetary policy can be said to be contractionary and vice versa. This means that the central bank is trying to reduce the money supply. So how do you determine whether a monetary policy is expansionary or contractionary? To do this, we need to understand the economy`s real trend rate and neutral interest rates. Governments pursue restrictive fiscal policies by raising taxes or cutting public spending. In its crudest form, this policy sucks money from the private sector in the hope of slowing down unsustainable output or driving down asset prices.

Nowadays, increasing the level of taxation is rarely seen as a viable contraction measure. Instead, most restrictive fiscal measures end the previous fiscal expansion by cutting public spending – and even then only in target sectors. A country`s central bank can pursue an expansionary or restrictive monetary policy. Expansionary monetary policy focuses on expanding or increasing the money supply in an economy. On the other hand, a contractionary monetary policy focuses on reducing the money supply in the economy. The central bank uses its monetary policy instruments to increase or decrease the money supply. Monetary policy adjustment usually reflects the source of inflation. If inflation is above target due to increased aggregate demand, a policy of contraction is appropriate. However, when inflation is high due to supply shocks, a monetary policy of contraction is not appropriate. All this has a direct effect on the interest rate.

When the Fed buys securities on the open market, the price of those securities rises. In my article on the reduction of dividend tax, we saw that bond prices and interest rates are inversely linked. The federal discount rate is an interest rate, so its lowering essentially lowers interest rates. If the Fed decides instead to lower reserve requirements, it will incentivize banks to increase the amount of money they can invest. This causes the price of assets such as bonds to rise, so interest rates have to fall. Whatever instrument the Fed uses to increase the money supply, interest rates will fall and bond prices will rise. The policy of contraction occurred especially in the early 1980s, when then-Federal Reserve Chairman Paul Volcker finally halted the rise in inflation of the 1970s. At their peak in 1981, target federal funds interest rates were approaching 20%.

Measured inflation rose from almost 14% in 1980 to 3.2% in 1983. Students who first learn economics often have difficulty understanding what contractionary monetary policy and expansionary monetary policy are and why they have the effects they have. In general, contractionary monetary policy and expansionary monetary policy involve changing the amount of money in a country. Expansionary monetary policy is simply a policy that expands (increases) the money supply, while contractionary monetary policy reduces (decreases) a country`s money supply. Restrictive monetary policy is driven by increases in the various policy rates controlled by modern central banks, or by other means that lead to the growth of the money supply. The goal is to reduce inflation by limiting the amount of active money circulating in the economy. It also aims to suppress unsustainable speculation and capital investment that may have triggered previous expansionary measures. Although the initial effect of contraction policies is to reduce nominal gross domestic product (GDP), which is defined as gross domestic product (GDP) valued at current market prices, this often ultimately leads to sustainable economic growth and smoother business cycles.

If contraction policies reduce the degree of displacement in private markets, this can have a stimulating effect by allowing the private or non-governmental part of the economy to grow. This was true during the forgotten depression of 1920-1921 and in the period immediately after the end of World War II, when leaps in economic growth followed massive cuts in public spending and rising interest rates. If you would like to ask a question about contractionary monetary policy, expansionary monetary policy or any other topic, or comment on this story, please use the feedback form. Contraction policy is a monetary measure that refers either to a reduction in public spending – especially deficit spending – or to a reduction in the rate of monetary expansion by a central bank. It is a kind of macroeconomic tool to combat rising inflation or other economic distortions caused by central banks or government intervention. The policy of contraction is the exact opposite of expansive politics. When interest rates are lower, the cost of financing capital projects is lower. So when everything else is the same, lower interest rates lead to higher investment rates. Higher U.S.

bond prices will have an impact on the foreign exchange market. Rising U.S. bond prices will encourage investors to sell these bonds in exchange for other bonds, such as bonds. B Canadian. Thus, an investor will sell his U.S. bond, exchange his U.S. dollars for Canadian dollars and buy a Canadian bond. As a result, the supply of U.S.

dollars in foreign exchange markets increases and the supply of Canadian dollars in foreign exchange markets decreases. As my beginner`s guide to exchange rates shows, this causes the U.S. dollar to lose value against the Canadian dollar. The lower exchange rate makes goods produced in the United States cheaper in Canada and goods produced in Canada more expensive in America, so exports will increase and imports will decrease, leading to an increase in the trade balance. The real trend rate, also known as the trend rate, is the long-term sustainable real growth rate of an economy. This is the rate that an economy can maintain without inflationary pressures. This rate is not directly observed and must be estimated. The rate also changes as economic conditions change. For example, if an economy has been consumption-oriented for a few years and it has been supported by debt, and then the focus is on deleveraging and increasing savings, the trend rate will decrease.

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