Monetary policy can be expansionary or contractionary in nature, depending on the actions taken by central banks, which oversee a nation's monetary policy decisions. Expansionary monetary policy, often enacted during slow economic conditions, expands the money supply and eases access to credit. Central banks enact contractionary monetary policy, reducing the money supply, when inflation threatens the economy.
Monetary policy refers to the actions governing a nation's money supply. Central banks, such as the Bank of England and the U.S. Federal Reserve, enact monetary policy. Actions taken by central banks to affect a nation's supply of money include open market operations, or the sale and purchase of government bonds; changing the amount of money banks must hold in reserve; and setting the discount rate, an interest rate that the central bank charges financial institutions for short-term loans. In addition, the U.S. Federal Reserve uses the federal funds rate, or the rate banks charge each other for overnight loans, to manage the money supply. These policy actions can be expansionary or contractionary, depending on whether central bankers intend to expand or reduce the money supply.
Expansionary policy increases a nation's money supply. Central banks enact expansionary measures by lowering the discount rate or buying government bonds, which injects more money into the economy. Lowering reserve requirements expands the money supply as well, by allowing banks to engage in more lending. In the United States, the Federal Reserve's policy-making body, known as the Federal Open Market Committee, lowers the federal funds rate when it wants to expand the money supply, according to Investopedia.
When consumer spending is robust and credit is easy to obtain, inflationary pressures may result, causing prices to rise. If inflation rises higher than expected, central banks use contractionary monetary policy to slow the pace of the economy and reduce inflation. Investopedia reports that contractionary monetary policy tries to reduce the money supply and slow the rapid pace of economic activity by taking money out of circulation and making credit more difficult to obtain. Central banks reduce the money supply by raising the discount rate, increasing the amount of money banks must hold in reserve and selling government bonds, which takes money out of circulation. In the United States, raising the federal funds rate is a contractionary monetary policy action.
Expansionary and contractionary monetary policies come with risks. Investopedia cautions that policy makers must exercise caution with expansionary policy to avoid causing inflation. In addition, neither expansionary nor contractionary policies have immediate effects. Both types of policy take time to work their way through the economy.
The Federal Reserve Bank of San Francisco acknowledges that expansionary and contractionary monetary policies involve conflicting goals, namely, economic stabilisation and maintenance of low inflation, respectively. An overly expansionary monetary policy could result in inflation, meaning that policy makers must strike a balance between the conflicting goals of stabilisation and low inflation.