But when inflation exceeds its target growth rate of 2%, it acts as a warning – and becomes the main catalyst for the implementation of a contractionary monetary policy. Promoting capital investment creates additional jobs in the economy. Therefore, an expansive monetary policy generally reduces unemployment Structural unemploymentStructural unemployment is a category of unemployment caused by differences in the qualifications of the unemployed population and unemployment. The result of the increase in the price of credit, goods and money itself: a reduction in consumer and business spending, a decrease in demand. When demand falls, prices fall – and inflation is brought under control. Runaway inflation is not a common problem. This, combined with the fact that governments want a growing economy, means that contractionary monetary policy has not been used as often. Injecting extra money into the economy increases inflationInflation is an economic concept that refers to the increase in the price level of goods over a period of time. The increase in the price level means that money loses purchasing power in a given economy (i.e.

less can be bought with the same amount of money). Levels. This can be both beneficial and detrimental to the economy. Excessive increase in the money supply can lead to unsustainable levels of inflation. On the other hand, rising inflation can prevent possible deflation, which can be more damaging than reasonable inflation. If a country`s GDP grows too fast and inflation exceeds a desirable rate of 2%, central banks will implement a monetary policy of contraction. Another step the Fed is taking to contract the money supply is to sell U.S. Treasury bonds and notes – a process known as open market operations. To curb demand and reduce the money supply, the Federal Reserve raises short-term interest rates – two of them: the policy of contraction aims to prevent possible distortions of capital markets. Distortions include high inflation due to a growing money supply, unreasonable asset prices or crowding-out effects, when a rise in interest rates leads to a reduction in private investment spending, which slows down the initial increase in total investment spending. Banks could then issue smaller loans or raise their lending standards.

This leads to the same scenario where less money circulates and banks` lending rates are increased, making borrowing more expensive. Short-term interest rate adjustments are a central bank`s most important monetary policy instrument. Commercial banks can usually borrow short-term from the central bank to cope with their liquidity constraints. In exchange for loans, the central bank charges a short-term interest rate. By lowering short-term interest rates, the central bank reduces the cost of borrowing from commercial banks. As might be expected, it is implemented in the opposite period of an economic cycle: a period of contraction during which the economy slows down and GDP declines. The policy of contraction occurred especially in the early 1980s, when then-Federal Reserve Chairman Paul Volcker finally halted the rise in inflation of the 1970s. At their peak in 1981, target federal funds interest rates were close to 20 per cent. The measured inflation rate rose from almost 14% in 1980 to 3.2% in 1983.

Expansionary monetary policy reduces the cost of borrowing. As a result, consumers tend to spend more, while companies are encouraged to make larger capital investments. The goal is to slow down the pace of the economy by reducing the amount of money or the amount of cash and easily withdrawn funds circulating throughout the country. This is the opposite of expansionary monetary policy. When there is no demand, companies sell fewer goods and services, which reduces profits, forces them to cut costs and lay off workers, which increases unemployment, which leads to less money in the economy, which further reduces demand. If contraction policies reduce the extent of displacement in private markets, they can have a stimulating effect by increasing the private or non-governmental part of the economy. This was true during the forgotten depression of 1920-1921 and in the period immediately after the end of World War II, when leaps in economic growth followed massive cuts in public spending and rising interest rates. Contraction policies are often linked to monetary policy, with central banks such as the Federal Reserve being able to implement this policy by raising interest rates. The purpose of contractionary monetary policy is to prevent these raw shocks. .