Contractionary Policy
Government or central bank actions designed to slow economic growth and reduce inflation by tightening money supply or reducing spending.
What is Contractionary Policy?
Contractionary policy encompasses fiscal and monetary measures intended to reduce aggregate demand, cool an overheating economy, and bring inflation under control. On the monetary side, central banks raise interest rates and reduce the money supply through open-market securities sales or higher reserve requirements. On the fiscal side, governments cut spending or raise taxes to reduce the budget deficit or generate a surplus. Contractionary policy carries trade-offs: while it lowers inflation, it also slows economic growth, increases unemployment, and can tip an economy into recession if applied too aggressively.
Example
Faced with inflation reaching a 40-year high of 9.1% in June 2022, the Federal Reserve launched the most aggressive contractionary monetary policy cycle since the 1980s. The Fed raised the federal funds rate from near zero to a range of 5.25%–5.50% by mid-2023 — 525 basis points in about 16 months — sharply reducing mortgage availability and slowing consumer and business borrowing.