Question

A friend says the following: "I understand why the Fed uses expansionary policy, but I don't understand why it would ever use contractionary policy. Why would the government ever want the economy to contract? Briefly answer the friend's question with at least 200 words and one reference in APA format.

Answer 1

Contractionary policy is used to fight inflation. Under this policy,money supply is decreased to increase the cost of borrowing. When cost of borrowing increases, GDP decreases as loans are not taken by companies to increase their producing capacity. This inturn dampens the inflation.

The Central bank decreases the money supply in various ways.It could be by increase in the discount rate or sale of government bonds or increase in the required reserve ratio or by carrying out all the changes simultaneously.

  A notable use of contractionary policy occurred in the early 1980s when the then-Fed Chairman Paul Volcker ended the soaring inflation of the 1970s. At their peak in 1981, target federal fund interest rates were close to 20%. Measured inflation levels declined from nearly 14% in 1980 to less than 3% in 1983.

In the United States, contractionary policy is implemented by raising the target federal funds rate.This is done by increasing the rate that banks charge each other overnight to meet their reserve requirements. The Fed can also raise reserve requirements for member banks, shrinking the money supply, or perform open-market operations by selling assets, such as U.S. Treasuries, to large investors. This lowers the market price of such assets and increases their yields, making it more economical for savers and bondholders

Basic aim of using contractionary policy as a fiscal policy is to take money out of the private economy in order to slow down unsustainable production or to lower the prices of the assets.