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Video:What Is Restrictive Monetary Policy?

with Zach Toombs

Restrictive monetary policy is enacted under specific economic circumstances. This About.com video will go into greater detail explaining restrictive monetary policy.See Transcript

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Transcript:What Is Restrictive Monetary Policy?

Hi, I'm Zach Toombs for About.com, and today, we're explaining the concept of restrictive monetary policy.

Restricting the Money Supply

What is that? In short, it's when the Federal Reserve Bank restricts the money supply released into the economy, hoping to slow down, or restrict, economic growth. This usually happens when the Fed is concerned that the economy could heat up too fast, and is heading toward inflation.

When the Fed restricts an economy, it means there is less money for banks to lend. As the Fed restricts the money supply, and interest rates rise, economic growth slows, people get laid off, and demand drops.

Rising prices, and hyperinflation, is what constrictive monetary policy wards off. It doesn't create it. The concern if an economy gets too hot is hyperinflation, where prices can skyrocket due to too great a demand and too short a supply.

In order to ward off inflation, the Federal Reserve may choose to make those purchases even more expensive, particularly for people who take on loans to make purchases. By raising the interest rate of borrowing, it can make big ticket purchases -- cars, homes and some durable goods like appliances -- too expensive. In effect, by raising the cost of borrowing, consumers decide not to make the purchase, and instead, choose to save their money. This can have a cooling effect on the economy.

Implementing Restrictive Monetary Policy

The Fed uses a handful of means to implement restrictive monetary policy:

  • It can raise the Federal funds rate, the rate banks charge on another for deposits.
  • It can require a greater reserve of cash for banks, restricting what they can lend.
  • It can sell treasury notes and bills to these banks to increase their reserves, but this also means they have less cash to lend.
  • It can raise the discount rate, the rate it charges to banks who want to take loans.
  • It can raise the reserve requirement, a rare action reserved for worst case scenarios.

Restrictive vs. Expansive Policy

The opposite of restrictive monetary policy is expansive policy, such as the quantitative easing exhibited of late by the Federal Reserve to induce the economy into activity. With expansive policy, the concern is that the economy is too sluggish, and people are unwilling to spend.

The last period of prolonged inflation occurred in the United States throughout the 1970s, followed by three decades of modest price inflation overall. The Fed accepts a 2% inflation rate as healthy for economic growth. That's because it spurs demand, since people buy now to avoid future price increases.

And that's a short look at restrictive monetary policy. For more information, check out About.com.

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