Expansionary and Contractionary Monetary Policies

Contractionary and expansionary policies involve modification of the level of money supply in an economy. An expansionary policy increases the supply of money in an economy. On the other hand, a contractionary policy decreases the supply of a country’s currency.

Expansionary Policy

When central banks want to increase the money supply, they do the following:

• buy securities in the open market;
• reduce the discount rate; or
• lower the reserve requirements.

Each one of these actions affects the interest rate.

Open Market Operations

When the central bank purchases securities in the open market, it increases security prices. Because of the inverse relationship between bond prices and interest rates, increasing bond prices will decrease interest rates.

The increase in bond prices will also affect the exchange market. For example, the rise in American bonds will result in investors selling these bonds in exchange for other bonds, say Australian bonds. As a result, the supply of American dollars will increase in the foreign exchange market while the supply of Australian currency will decline.

Discount Rate

A discount rate is an interest rate, so when it is lowered, it leads to reduced interest rates. Given such a development, businesses and consumers will be more willing to take loans. This, in turn, will increase consumption and investments.

Reserve Requirements

When the central bank lowers reserve requirements, commercial banks increase the sum of money they can lend to consumers and businesses. This also increases consumption and investments.

Contractionary Policy

The effects of contractionary policies are the opposite of expansionary policies. They cause a reduction in bond prices and an increase in interest rates. When the central bank wishes to lower the money supply, it can do the following:

• sell securities in the open market;
• increase the discount rate; or
• increase the reserve requirements of commercial banks.

High interest rates cause the levels of capital investment to decrease. Further, interest rates make domestic bonds more enticing. This causes an increase in the demand for domestic bonds while the demand for foreign bonds declines. As a result, the supply of domestic currency decreases in the foreign exchange market.

Question

Which of the following is most likely an example of a central bank action if it wants to decrease the money supply?

A. Buying securities in the open market

B. Lowering the reserve requirements

C. Increasing the discount rate

Solution

The correct answer is C.

Increasing the discount rate would have the effect of lowering the money supply.

Options A and B are incorrect. Buying securities in the open market and lowering the reserve requirements are ways the central bank can increase the money supply.

Reading 16 LOS 16m:

Determine whether a monetary policy is expansionary and contractionary