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.
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.
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.
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.
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.
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.