What is contractionary monetary policy?

Expansionary and contractionary monetary policy examples

The central bank controls the supply of (fiat) money.

The demand for money (velocity) is variable.

The intersection of supply and demand for money (just like it is in any market) determines the value of money.

,Money tends to have relatively stable value.

With most fiat money, there is generally a long-term trend of a slight decline in value over time (= low inflation).

,Contractionary monetary policy, is when the central bank chooses to supply less money than required (given current demand), in order to keep the value of money on its trend line.

This is easiest seen by looking at nominal aggregates, such as NGDP, or inflation.

E.

g.

if inflation had been 2% annually for the last decade, and then suddenly one year it was 1% instead, that would indicate contractionary monetary policy.

,Whats the significance of contractionary vs.

expansionary monetary policy? Primarily because of sticky wages (and debts and prices), long-term contracts have baked in assumptions about the future value of money.

When those assumptions dont come to pass, unfortunately prices dont adjust quickly.

It is during the period (perhaps lasting years) while prices are adjusting, that these nominal factors can have real effects.

,Contractionary monetary policy causes a rise in unemployment, a lowering of productive output, and a drop in inflation (i.

e.

, a recession).

Expansionary monetary policy causes a drop in unemployment, a rise in output, and a rise in inflation.

,For a concrete example, the drop in US NGDP in 2008 was the greatest annual decline in NGDP trend line since the Great Depression in the 1930s, indicating tremendously contractionary monetary policy at that time.

And the consequences (widespread unemployment, loss of output) could be easily predicted.

,C.

f.

Market Monetarism

Types of monetary policy

Congress has directed the Fed to conduct the nations monetary policy to support three specific goals: maximum sustainable employment, stable prices, and moderate long-term interest rates.

The Fed seeks to achieve these goals by influencing interest rates and general financial conditions.

Other federal reserves such as the German Bundesbank has a more simple and focused mandate: to keep the price of their currency stable by limiting inflation.

,There is often debate as to which mandate makes more sense (U.

S or German as an example).

The difficulty with the US fed reserve mandate is the goals are not always aligned.

For example, many fed officials believe that a reasonably higher inflation rate than the public is aware of creates a lower unemployment rate since wages donu2019t go up as much as prices do - the belief is this creates lower unemployment, known as the Philips Curve.

However by creating more inflation to lower unemployment, prices become more unstable, especially as it relates to assets.

Since the objectives are contradictory, Fed officials tend to focus more on the short term unemployment objective than long term stability.

However, when rates are kept too long, more liquidity and leverage come through the banks and often create asset bubbles and significantly larger retractions than otherwise would have happened.

,Below are two graphs.

The first showing a relationship between inflation and unemployment.

The second shows the relationship between keeping rates low and increases in the S&P 500.

Overtime, the increases and decreases in asset markets have become much larger with rates being lower over a longer period.