A contractionary policy is a way for the government to cut back on spending or slow down how much money is being pumped into the economy by the central bank. It’s a strategy used to tackle inflation when prices start to climb.
In the U.S., some common contractionary measures include hiking interest rates, boosting the reserve requirements for banks, and selling off government securities.
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Contractionary policies are designed to prevent potential issues in the capital markets. These issues can include high inflation due to an increasing money supply, inflated asset prices, or crowding-out effects, where rising interest rates cut back on private investment, ultimately reducing the overall investment growth.
Initially, contractionary policies can lead to a drop in nominal gross domestic product (GDP), which is the GDP calculated at current market prices. However, in the long run, they often promote sustainable economic growth and help stabilize business cycles.
A notable instance of contractionary policy took place in the early 1980s when Federal Reserve chair Paul Volcker tackled the rampant inflation of the 1970s. By 1981, the target federal fund interest rates were close to 20%. Inflation rates fell dramatically from nearly 14% in 1980 to just 3.2% by 1983.
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In short, nominal GDP measures the economic production at current market prices, whereas real GDP measures the economic production factoring in any prices changes in the market (deflation or inflation).
Conclusion
A contractionary policy is a strategy aimed at cutting down government spending or slowing down the money supply growth by a central bank to tackle inflation. In the U.S., common contractionary measures include hiking interest rates, boosting bank reserve requirements, and selling off government securities. These policies can be tricky to put into action since they might lead to higher taxes, increased unemployment, and cuts to government programs and subsidies.