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Contractionary monetary policy
Neoclassical and Keynesian economics significantly differ on the effects and effectiveness of monetary policy on influencing the real economy; there is no clear consensus on how monetary policy effects real economic variables (aggregate output or income, employment). Both economic schools accept that monetary policy affects monetary variables (price levels, interest rates).
Contractionary policy can be implemented by reducing the size of the monetary base. This directly reduces the total amount of money circulating in the economy. In the United States, the Federal Reserve can use open market operations to reduce the monetary base. The Federal Reserve would sell bonds in exchange for hard currency. When the Federal Reserve collects this hard currency payment, it removes that amount of currency from the economy, thus contracting the monetary base. Note that open market operations are a relatively small part of the total volume in the bond market, thus the Federal Reserve is not able to influence interest rates through this method.
The monetary authority exerts regulatory control over banks. Contractionary policy can be implemented by requiring banks to hold a higher proportion of their total assets in reserve. Banks only maintain a small portion of their assets as cash available for immediate withdrawl; the rest is invested in illiquid assets like mortages and loans. By requiring a higher proportion of total assets to be held as liquid cash, the Federal Reserve reduces the availablilty of loanable funds. This acts as a reduction in the money supply.
Discount Window Lending
Many central banks or finance ministries have the authority to lend funds to financial institutions within their country. The lended funds represent an expansion in the monetary base. By calling in exisiting loans the monetary authority can directly reduce the size of the money supply. By advertising that the discount window will reduce future lending, the monetary can also indirectly reduce the money supply by reducing risk-taking by financial institutions.
Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In the United States, the Federal Reserve can only directly set the Federal Funds Rate. This rate has some effect on other market interest rates, but there is no direct, definite relationship. In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By raising the interest rate(s) under its control, a monetary authority can contract the money supply, because higher interest rates encourage savings and discourage lending. Both of these effects reduce the size of the money supply.
Monetary Policy and Inflation
Monetary policy can be used to control inflation. Inflation is defined as continuing increases in price levels. Since price level is a monetary variable, monetary policy can affect it. Contractionary monetary policy has the effect of reducing inflation by reducing upward pressure on price levels.
Note that inflation can also be affected by fiscal policy. However, contractionary fiscal policy is often politically unpopular, because it involves spending cuts and tax increases. Thus, politicians favor the use of monetary policy to control inflation.
Monetary Policy and the Real Economy
As noted above, the relationship between monetary policy and the real economy is uncertain. It is important to note that contractionary monetary policy should not be confused with economic contraction. The latter being a reduction in economic output in the real economy.
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