CONTRACTIONARY MONETARY POLICY–THE LIMITER OF INFLATION

Inflation is a rise in the general price level of goods and services in a country in a given period.

Monetary policy can be used to control inflation. When the Central bank contracts money supply, it seeks to limit inflation.

At least two types of inflation can be reduced through a reduction in money supply: These are demand-pull inflation and monetary inflation.

Demand-pull inflation occurs when aggregate demand grows sharply as a result of a large increase in consumer spending, investment spending, and government spending.

Monetary inflation, on the other hand, is the rise in the average prices of goods and services caused by excessive growth in the money supply in the economy.

Because the central bank can control the money supply and influence aggregate demand, it is in a better position to limit both monetary and demand-pull inflation.

To achieve its goal of limiting inflation, the central bank engages in tough or contractionary monetary policy.

A contractionary monetary policy is a reduction in monetary policy to fight inflation.

There are four contractionary monetary policies used by the central bank. These are

1. Increase bank rate: Bank rate is the rate at which the central bank provides lends to the commercial banks. It is also referred to as the monetary policy rate (MPR)

The central bank increases the bank rate whenever it wishes to reduce the money supply.

This is because if the bank rate rises, banks will raise their lending rates as well.

With high lending rates, businessmen and industrialists alike will be discouraged from borrowing loans from commercial banks.

As a result, the money supply shrinks, which helps to reduce money inflation. Because the money supply has shrunk, household consumption and business spending will decrease as well, resulting in a drop in aggregate demand, which is required to fight demand-pull inflation.

Therefore, an increase in bank decreases money inflation and demand-pull inflation

2. Increase in cash reserve ratio: Also known as reserve requirement is the minimum amount that banks must hold in reserve against cash deposits.

If, for example, the reserve requirement is 10%, banks must hold €10,000 in reserve for every deposit of €100,000. The remaining €90,000 is loaned out.

so, If the central bank raises the cash requirement to 20%, then banks must hold €20,000 in reserve for every deposit of €100,000.

The effect is that commercial banks will reduce their credit, resulting in a reduction in the money supply. 

Because the money supply has reduced, the interest rate (which is the price of money) will rise, causing a drop in investment spending which would have the contractionary effect of lowering aggregate demand which is necessary for fighting inflation.

Thus, we see an increase in the cash reserve ratio can help inflation.

3. Selling of government securities: Central bank also trades securities in. This is collectively known as open market operations.

When the central bank sells securities in the open market, it receives payment in the form of a cheque from a commercial bank.

Following this, commercial bank's balance, which is kept with the commercial banks, reduces by the same amount.

Furthermore, because the cash balance has been reduced, the bank has to reduce the cash it loaned out to meet its reserve requirement, resulting in a reduction in the money supply.

Because the money supply has reduced, the interest rate must rise, resulting in a drop in investment spending which would eventually reduce aggregate demand. Since money supply and aggregate demand have decreased, both money and demand-pull inflation must fall. 

4. Increase margin requirement: This is the difference between the loan amount and the market value of security pledged as collateral for the loan.

For example, if the margin requirement is 10%, then borrowers must provide €120,000 in collateral to obtain a €108,000 loan 

Assuming, the central bank raises the margin requirement to 20%, borrowers will be able to obtain a loan of €96,000 with the same €120,000 worth of securities.

As a result, the demand for loans will decrease as borrowing becomes more expensive. As demand for loans decreases, funds necessary for investment may become unavailable, which would reduce aggregate demand.

Bottom line

The basic goal of contractionary goal is to reduce inflation (both demand-pull and monetary inflation).

By reducing the money supply and increasing inflation, the central bank hopes to reduce inflation.

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