Contractionary Monetary PolicyAs you can probably imagine, the effects of a contractionary monetary policy are precisely the opposite of an expansionary monetary policy. In the United States, when the Federal Open Market Committee wishes to decrease the money supply, it can do a combination of three things:
- Sell securities on the open market, known as Open Market Operations
- Raise the Federal Discount Rate
- Raise Reserve Requirements
What We've Learned About Contractionary Monetary Policy:
- Contractionary monetary policy causes a decrease in bond prices and an increase in interest rates.
- Higher interest rates lead to lower levels of capital investment.
- The higher interest rates make domestic bonds more attractive, so the demand for domestic bonds rises and the demand for foreign bonds falls.
- The demand for domestic currency rises and the demand for foreign currency falls, causing an increase in the exchange rate. (The value of the domestic currency is now higher relative to foreign currencies)
- A higher exchange rate causes exports to decrease, imports to increase and the balance of trade to decrease.