Alternate name: Contractionary monetary policy
Inflation is the rise in the price level of items, such as groceries or clothes, over time. To minimize or slow down inflation, a central bank could make it more expensive for consumers to spend money and businesses to borrow money by raising interest rates. This is a form of contractionary monetary policy—it restricts, or contracts, spending. Each central bank has monetary tools that it can use to influence inflation and money supply. For example, the central bank of the U.S., the Federal Reserve, has three main monetary tools: open-market operations, the discount rate, and reserve requirements. Other central banks use similar tools. For example, the Bank of England uses the bank rate—which is similar to the Federal Reserve’s discount rate—and asset purchases as its primary monetary tools.
How Does Tight Monetary Policy Work?
In the U.S., changes to monetary policy occur at the Federal Open Market Committee (FOMC) meetings. If the Fed wants to raise the federal funds interest rate to “tighten” or “restrict” the money supply, it could sell bonds to banks. When this happens, banks will have less money available to loan out, which increases competition to borrow funds. It can also increase the federal funds rate. When the federal funds interest rate moves, so do other market interest rates, such as the prime rate, which can influence interest rates on mortgages, loans, and savings accounts. As interest rates rise, you may find yourself spending less money, and businesses may invest or borrow less. This can all help slow economic growth and inflation.
When Would a Central Bank Use Tight Monetary Policy?
The Fed has two primary goals when it comes to U.S. monetary policy: maximum employment and price stability. When it comes to price stability, the long-run goal for average inflation is 2%. When the outlook for average inflation is higher than 2%, the Federal Reserve will look to enact tight monetary policy. When inflation is too high, it could lead to prices moving faster than wages and a loss of purchasing power for consumers. Purchasing power refers to the goods and services that a consumer typically buys with a set amount of money. If inflation makes prices rise, you may not be able to buy the same amount of goods and services you used to buy in the past. If there is expected to be higher inflation, you may buy more goods now to avoid paying higher prices later. In order to keep up with this type of increase in demand for goods, businesses would need to increase production and raise prices if they cannot produce more. This could further raise the prices of goods and cause more inflation. To avoid this, the Federal Reserve enacts tight monetary policy. Conversely, a low inflation rate or deflation, which is a decrease in the price level, means that prices in the future could be even lower than today. If you begin to expect that prices in the future will be lower than today’s prices, you might delay purchasing goods, and businesses will delay taking on new investment projects. This could slow economic growth. The Fed would then use expansionary monetary policy. In this case, it would decrease interest rates, so businesses take on new investments and you spend more money.
How Often Does the Federal Reserve Use Tight Monetary Policy?
Tight monetary policy is meant to “contract” or slow down the economy. Since the Federal Reserve wants to keep the economy growing, contractionary monetary policy has only been used sparingly to cool off the economy. However, if there is high enough expected inflation, the Federal Reserve will have to act to combat the negative effects of prices increasing rapidly. By the end of 2021, U.S. inflation reached levels not seen since the 1980s. In December 2021, inflation was 7%. Remember—the Fed targets an inflation rate of 2%, so 7% was much higher than its target. By March 2022, inflation was 8.5%. As a result of that high inflation, the FOMC announced at its March 2022 meeting that it would increase the target fed funds rate by 25 basis points, to 0.25% to 0.50%. It was the first time the Fed has raised rates since 2018. This is a good example of how the Fed uses its tools through tight monetary policy to raise the federal funds rate with hopes of cooling inflation.
