What Is the Difference Between Contractionary & Expansionary Monetary Policy?

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What Is the Difference Between Contractionary & Expansionary Monetary Policy?
Monetary policy aims to stimulate economic activity while curbing inflation. (money graph image by Sid Viswakumar from Fotolia.com)

Both contractionary and expansionary monetary policies are tools available to a country's central bank whose aim is to reduce or increase the money supply and ultimately spending on goods and services. The aim of a contractionary policy is to reduce the supply of money to the economy and thus curb inflation while expansionary policy aims to increase the supply of money and thus stimulate economic activity.

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Monetary Policy Goals

Monetary policy in the U.S. has the basic goals of promoting "maximum" sustainable output and employment and to promote "stable" prices. These goals are prescribed in a 1977 amendment to the Federal Reserve Act. As James Tobin wrote in the Concise Encyclopedia of Economics, recessions and booms reflect fluctuations in demand rather than in the economy's productive capacity, while monetary policy tries to damp, perhaps even eliminate, those fluctuations.

What Is the Difference Between Contractionary & Expansionary Monetary Policy?
Monetary policy tries to damp fluctuations in the economy. (money, money, money image by easaab from Fotolia.com)

Expansionary Monetary Policy

During periods of low economic growth or recession, a national bank can help its country's economy by supplying it with extra money. The U.S. Federal Reserve, which is the country's national bank, uses expansionary policies when it lowers the basic interest rate at which it lends money to other banks in the country. Another way of injecting capital directly into the economy is by buying treasury bonds on the open market. Expansionary policies can also come in the form of tax cuts or increased rebates, and increased government spending.

What Is the Difference Between Contractionary & Expansionary Monetary Policy?
Expansionary policy stimulates spending. (money money image by Valentin Mosichev from Fotolia.com)

Contractionary Monetary Policy

Contractionary policies are applied when it is necessary to reduce the money supply and curb spending in a country. When spending and the availability of money are high, prices start to rise, which is known as inflation. A national bank can reduce the supply of money by raising the basic interest rate, which makes borrowing more expensive. It can also tell banks to keep more money in mandatory reserves, thus reducing the amount banks can lend to clients.

What Is the Difference Between Contractionary & Expansionary Monetary Policy?
Reduced money supply keeps inflation under control. (money money money image by Tribalstar from Fotolia.com)

Pros and Cons

Whether it applies an expansionary or a contractionary monetary policy, the Fed has to balance the benefits against risks. Increased money supply means more economic activity, but a greater chance of higher inflation. A reduced money supply means lower inflation, but a drop in economic activity.

What Is the Difference Between Contractionary & Expansionary Monetary Policy?
Balancing benefits against risks is not an easy task. (the balance is an emblem of justice image by Pali A from Fotolia.com)

Time Considerations

When considering monetary policy, economists must take into account the time lag between their policy move and its effects on the economy. Major effects on output can take from three months to two years while the effects on inflation take even longer, perhaps one to three years, according to the Federal Reserve Bank of San Francisco website.

What Is the Difference Between Contractionary & Expansionary Monetary Policy?
Effects of a policy change take time to materialise. (time of the incomes, time of the expenses. image by firsov from Fotolia.com)

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