Expansionary and Contractionary Monetary Policies

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.


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


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

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop GMAT® Exam Prep

    Sergio Torrico
    Sergio Torrico
    Excelente para el FRM 2 Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
    So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts. The fun light-hearted analogies are also a welcome break to some very dry content. I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
    Kriti Dhawan
    Kriti Dhawan
    A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them. Thank you ! Grateful I saw this at the right time for my CFA prep.
    nikhil kumar
    nikhil kumar
    Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
    Great support throughout the course by the team, did not feel neglected
    Benjamin anonymous
    Benjamin anonymous
    I loved using AnalystPrep for FRM. QBank is huge, videos are great. Would recommend to a friend
    Daniel Glyn
    Daniel Glyn
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.