The opposite of open market restrictive operations is called quantitative easing. Then the Fed buys government bonds, mortgage-backed securities, or bonds of its member banks. This is an expansionary policy because the Fed simply creates credit out of thin air to buy these loans. When this is the case, the Fed “prints money.” Governments pursue restrictive fiscal policies by raising taxes or cutting public spending. In its crudest form, this policy sucks money from the private sector in the hope of slowing down unsustainable output or driving down asset prices. Nowadays, increasing the level of taxation is rarely seen as a viable contraction measure. Instead, most restrictive fiscal measures end the previous fiscal expansion by cutting public spending – and even then only in target sectors. Figure 4 shows how the Federal Reserve has conducted monetary policy in recent decades by targeting the key federal funds interest rate. The chart shows the interest rate on federal funds (remember that this interest rate is set by open market operations), the unemployment rate, and the inflation rate since 1975.

Various episodes of monetary policy during this period are presented in the chart. In the United States, the Federal Reserve`s monetary policy of contraction consists of three main instruments: former Fed Chairman Ben Bernanke said that the contraction policies caused the Great Depression. The Fed had introduced restrictive monetary policy to curb the hyperinflation of the late 1920s. During the recession or stock market crash of 1929, it did not move to expansionary monetary policy as it should have. It continued its policy of contraction and raised interest rates. The objective of a restrictive monetary policy is to prevent inflation. A little inflation is healthy. An annual price increase of 2% is actually good for the economy because it stimulates demand. People expect prices to be higher later, so they can buy more now. This is why many central banks have an inflation target of around 2%.

When the PCE index of core inflation is well above 2%, the Fed conducts a monetary policy of contraction. An expansive monetary policy stimulates the economy. The central bank uses its tools to increase the money supply. It often does this by lowering interest rates. It can also take advantage of expansive open market operations called quantitative easing. Restrictive monetary policy slows down the money supply by reducing the money supply. The U.S. Federal Reserve calls when to do this. It can slow down the economy, for example, by increasing the interest rate at which it lends money to banks or at which banks can borrow from each other. Banks are responding by raising their own interest rates.

As loans become more expensive, consumer and business spending slows. Monetary policy affects interest rates and the amount of solvent assets available, which in turn affects several components of aggregate demand. A restrictive or restrictive monetary policy, which leads to higher interest rates and a decrease in the number of solvent assets, will reduce two components of aggregate demand. Business investment will decline because it is less attractive for companies to borrow money, and even companies that have money will find that at higher interest rates, it is relatively more attractive to invest these funds in an investment than to invest in physical capital. In addition, higher interest rates will discourage consumers from borrowing for large items such as homes and cars. Conversely, a loose or expansionary monetary policy that leads to lower interest rates and an increase in the amount of solvent funds will tend to increase business investment and consumer borrowing for large items. Consider the market for solvent bank funds shown in Figure 1. The initial equilibrium (E0) occurs at an interest rate of 8% and $10 billion in borrowed and borrowed funds.

Expansionary monetary policy will shift the supply of loanable funds from the initial supply curve (S0) to S1, resulting in equilibrium (E1) with a 6% lower interest rate and a borrowed average of $14 billion. Conversely, a restrictive monetary policy will shift the supply of loanable funds from the initial supply curve (S0) to S2, resulting in equilibrium (E2) with a higher interest rate of 10% and an amount of borrowed funds of $8 billion. The most powerful and widely used of the three traditional instruments of monetary policy – open market operations – works by increasing or reducing the money supply in a way that affects the interest rate. By the end of 2008, when the U.S. economy was in the throes of a recession, the Federal Reserve had already cut the interest rate to near zero. With the recession still ongoing, the Fed has decided to pursue innovative, non-traditional policies known as quantitative easing (QE). This is the purchase by central banks of long-term securities secured by public and private mortgages to provide credit and stimulate aggregate demand. For the period from the mid-1970s to the end of 2007, the Federal Reserve`s monetary policy can be broadly summarized by examining how it aligned the key interest rate using open market operations. Monetary policy that lowers interest rates and stimulates borrowing is called expansionary monetary policy or loose monetary policy. Conversely, a monetary policy that raises interest rates and reduces borrowing in the economy is a contractionary monetary policy or a restrictive monetary policy. This module examines how expansionary and contractionary monetary policy will affect interest rates and aggregate demand, and how these policies will affect macroeconomic objectives such as unemployment and inflation. Finally, let`s take a look at the Fed`s monetary policy practice over the past few decades.

In business, a booming economy where everyone has money to spend is not always a good thing. As a driver, the economy can overheat and cause inflation; Everyone has more money, but everything costs more. Restrictive monetary policy is a tool to cool an overheated inflation cycle. Economists question whether the shortcomings of this monetary policy outweigh the disadvantages. When this happens, a central bank will try to increase the money supply, which will make it easier to borrow and issue. And it uses the same monetary tools, but in the opposite way. Contraction policies are often linked to monetary policy, with central banks such as the Federal Reserve being able to implement this policy by raising interest rates. The Federal Reserve uses restrictive monetary policy to slow the economy and prevent inflation. This can prevent inflation from consuming purchasing power, but it also drives up the unemployment rate. Each monetary policy uses the same instruments. The main instruments of monetary policy are short-term interest ratesInterest rateAn interest rate refers to the amount a lender charges a borrower for each form of debt, usually expressed as a percentage of principal, reserve requirements and open market operations. A contractionary monetary policy uses the following variants of these instruments: There are not many examples of contraction monetary policy for two reasons.

First, the Fed wants the economy to grow, not contract. More importantly, inflation has not been a problem since the 1970s. When the economy is suffering from recession and high unemployment, and output is below GDP potential, an expansionary monetary policy can help the economy return to potential GDP. Figure 2(a) illustrates this situation. This example uses a short-run ascending Keynesian aggregate supply curve (SARS). The initial equilibrium during an E0 recession occurs at a production level of 600. Expansionary monetary policy will lower interest rates and stimulate investment and consumer spending, resulting in the shift of the initial aggregate demand curve (AD0) to the right towards AD1, so that the new equilibrium (E1) occurs at the potential GDP level of 700. A contractionary monetary policy is a type of monetary policy that aims to reduce the rate of monetary expansion in order to fight inflationInflation is an economic concept that refers to the increase in the price level of goods over a period of time. The increase in the price level means that money loses purchasing power in a given economy (that is, with the same amount of money, less can be bought). .