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  • Nardos Berehe (Ethiopia)

Contractionary vs Expansionary monetary policy in the eye of the public interest



Modifying the amount of money in an economy involves contractionary and expansionary strategies. An economy's money supply rises as a result of an expansionary policy. Contrarily, a contractionary policy reduces the money supply in a nation. CFI defines a contractionary monetary policy or tight money policy as a type of monetary policy that is intended to reduce the rate of monetary expansion to fight inflation. This will also result in slower economic growth and increased unemployment also referred to as contractionary monetary policy shocks. It is also found that ‘contractionary’ monetary policy shocks have an ambiguous effect on real GDP.


This policy indicates the decrease of money supply, this can be done through increases in interest rates and is often used to correct the inflationary problems of a business-cycle expansion. In theory, contractionary monetary policy can include, for example, selling Ghana Treasury securities through open market operations, an increase in the discount rate, and an increase in reserve requirements. In theory, open market operations are the primary tool of contractionary monetary policy.


Contractionary monetary policy is often supported by contractionary fiscal policy. It is a decrease in the quantity of money in circulation, with corresponding increases in interest rates, for the expressed purpose of putting the brakes on an overheated business-cycle expansion and addressing the problem of inflation. In days gone by, monetary policy was undertaken by decreasing the amount of paper currency in circulation. In modern economies, monetary policy is undertaken by controlling the money creation process performed through fractional-reserve banking.


Notably, the purpose of contractionary monetary policy is to lower rather than halt the rate of demand for goods and services. Therefore, a contractionary policy that raises interest rates can be employed to reduce inflation and return the economy to the dual mandate's price stability goal. On the other hand, the basic objective of expansionary policy is to boost aggregate demand to make up for shortfalls in private demand. It is based on the ideas of Keynesian economics, particularly the idea that the main cause of recessions is a deficiency in aggregate demand.


Expansionary policy is intended to boost business investment and consumer spending by injecting money into the economy either through direct government deficit spending or increased lending to businesses and consumers. Ultimately, both policies have downturns to them, and developing policies for each will depend on the countries’ aggregate demand and economic status. The adjustment to monetary policy usually reflects the source of inflation. If inflation is above target because of an increase in aggregate demand, the contractionary policy is suitable. However, if inflation is high because of supply shocks, then a contractionary monetary policy is not suitable.


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