Contractionary Monetary Policy

• Contractionary monetary policy


  Increase in interest rates
• Reasons why central banks raise interest rates


  • To reduce inflation
  • To discourage household and corporate debt
  • To promote more sustainable borrowing and lending
  • To encourage more saving
• Central banks raise interest rates


  Aggregate demand comes down
• Higher interest rates do not bring down cost-push inflation
• Raising interest rates can keep a lid on inflation expectations
• Discouraging household and corporate debt


  Reduces the pressure on the banking sector, reducing the chance of bank failure and systemic risk, reducing the overall risks of recession
• Promoting more sustainable borrowing and lending


  Only those who need to borrow and can afford higher interest rates will enter the market, reducing the chance of unsustainable growth, credit bubbles, and asset price bubbles
• Encouraging more saving


  Increases living standards for those living off savings, provides a safety net for households and businesses, and increases investment
• Higher interest rates


  Can make housing more affordable by cooling down demand
• Higher interest rates reducing AD


  Can help reduce a current account deficit
• Higher interest rates


  Provide space for interest rate cuts in the next crisis
• Cons of raising interest rates


  • Can shock the economy into a recession
  • Can make it harder for indebted households and businesses to service their debt
  • Can reduce business investment
  • Can worsen a current account deficit
• Higher interest rates


  Can lead to hot money inflows, strengthening the exchange rate, making imports cheaper and exports more expensive, worsening the current account deficit