Examples of Tight Monetary Policy and Their Definition
When a central bank attempts to keep inflation under control, tight monetary policy, also known as contractionary monetary policy, usually takes place. The economy may become overheated as a result of excessive consumer and business borrowing and spending, which might significantly increase the cost of products and services.
Contractionary monetary policy is another name for it.
The growth in prices of goods over time, such as food or clothing, is known as inflation. A central bank could increase interest rates to make borrowing money by firms and consumers more expensive in order to reduce or halt the rate of inflation. This type of monetary policy is contractionary in that it limits or contracts spending.
Each central bank has monetary tools at its disposal that it can employ to control the money supply and inflation. For instance, the Federal Reserve, the U.S. central bank, uses open-market operations, the discount rate, and reserve requirements as its three primary monetary tools. Similar tools are used by other central banks. For instance, the Bank of England’s principal monetary weapons are asset purchases and the bank rate, which is comparable to the Federal Reserve’s discount rate.
How Effective Is Tight Monetary Policy?
The Federal Open Market Committee (FOMC) meetings are where monetary policy adjustments are made in the United States.
Selling bonds to banks is one option the Fed has if it wishes to increase the federal funds rate in order to “tighten” or “restrict” the money supply.1 As a result, banks will have less money available to lend out, which will boost competition for borrowing money. Additionally, it might raise the federal funds rate. The prime rate and other market interest rates vary in tandem with changes in the federal funds rate, which can affect interest rates on savings accounts, loans, and mortgages.
You might find yourself spending less when interest rates climb, and corporations might borrow or invest less. All of this may aid in reducing inflation and economic growth.
What Situations Call For Tight Monetary Policy from a Central Bank?
When it comes to American monetary policy, the Fed’s two main objectives are price stability and maximum employment.
The long-term objective for average inflation in terms of price stability is 2%. The Federal Reserve will try to implement tight monetary policy when the forecast for average inflation is expected to be greater than 2%. Inflation that is excessively high may cause prices to rise faster than salaries and a reduction in consumers’ purchasing power.
The items and services that a person normally purchases with a certain amount of money are referred to as their purchasing power. You might not be able to purchase the same number of goods and services as you once could if inflation raises prices. If increased inflation is anticipated, you might purchase more items now to prevent having to pay more later.
Businesses would need to boost output and raise prices if they were unable to do so in order to keep up with this type of growth in demand for their products. This can lead to an increase in inflation and the cost of products. The Federal Reserve implements strict monetary policies to prevent this.
In contrast, a low rate of inflation or deflation, which is a drop in the level of prices, indicates that prices may fall even further from their current levels in the future. You might put off buying products if you start to believe that future prices would be less than current ones, and businesses may put off starting new investment initiatives as well. This might impede economic expansion. After that, the Fed would implement an expansionary monetary policy. In this instance, it would lower interest rates, causing firms to make new investments and you to increase your spending.
What Is the Frequency of Tight Monetary Policy by the Federal Reserve?
The goal of restrictive monetary policy is to “contract” or slow the economy. Contractionary monetary policy, which lowers interest rates, has only occasionally been employed to cool the economy because the Federal Reserve wants to keep it expanding. The Federal Reserve will have to take action to counter the unfavorable impacts of sharply rising prices, though, if predicted inflation is high enough.
The United States’ inflation rate surpassed 1980s levels before the end of 2021. Inflation in December 2021 was 7%. The Fed’s target inflation rate is 2%, therefore 7% was far higher than that. Inflation reached 8.5% in March 2022. The FOMC declared at its meeting in March 2022 that it would raise the target fed funds rate by 25 basis points, to 0.25% to 0.50%, as a result of the high inflation. It was the first rate increase by the Fed since last year.
This is a nice illustration of how the Fed raises the federal funds rate in an effort to curb inflation by employing its tools of strict monetary policy.