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What Is Restrictive Monetary Policy?

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  • Written By: Kristie Lorette
  • Edited By: O. Wallace
  • Last Modified Date: 02 September 2016
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A restrictive monetary policy is a tool that the federal government uses to increase interest rates when they are too low. The same policy is implemented when the employment rate is too high. In short, it is a way to slow down the economy and bring it to a more balanced or stable level.

In the US, the Federal Open Market Committee (FOMC) is a part of the Federal Reserve and plays a pivotal role in implementing monetary policies on behalf of the Federal Reserve. This is the committee that makes decisions on which tools to use to control the economy and steer it in the direction in which it needs to go. It is the FOMC meets, votes and decides on putting a restrictive monetary policy in place.

One way that such a monetary policy occurs is when the FOMC sells U.S. Treasuries. When people in the open market buy U.S. Treasuries, it takes more money out of circulation, putting this money in the hands of the federal government.

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Another way the federal government puts a restrictive monetary policy in place is increasing the discount rate. The discount rate is the interest rate at which banks that are a part of the Federal Reserve loan money to each other. When the discount rate increases, it decreases the amount of money that banks lend to each other. When banks have less money to lend then this also takes money out of circulation to the general public — keeping it in the hands of the government.

A third way that the Federal Reserve can deploy this type of monetary policy is to increase the reserve requirement. Each bank in the Federal Reserve system is required to maintain a certain level of money in the bank. The higher the reserve requirement is, the more money the bank has to save, which means the less money that the bank has to lend. When lending decreases then there is less money in circulation.

The ultimate goal of the restrictive monetary policy and the other policies the Federal Reserve employs is to create a stable economy. If the Federal Reserve sees that employment rates are high and rates are low, then they may deploy a restrictive monetary policy. If the opposite is true then the Fed uses tools to pour money into the system to get to the general public in order to stabilize an economy that is experiencing a high unemployment rate and high interest rate environment.

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ddljohn
Post 3

It seems odd that a government would ever want to slow down economic development, but sometimes it's necessary. When the economy grows too fast, supply cannot keep up with demand. Restrictive monetary policy reduce lending by discouraging consumers from spending more money. This allows supply to catch up.

In economy, extremes are not desirable. Growth should not be too slow or too fast. Inflation should not be too high or too low. It's all about balance and sustainability.

SteamLouis
Post 2

@SarahGen-- Like the article said, it could be done by allowing banks to keep a part of their reserve requirements. This can be beneficial if the US dollar is losing value. A foreign currency could also be used by the Central Bank to buy US dollars.

But these are not the best options because eventually, reserves will be depleted. So these are temporary solutions. It's better to increase interest rates to where they should be.

Governments of some countries have an aversion to high interest rates, sometimes for political reasons. But when inflation is high and the national currency is losing value, the first immediate action that must be taken is raising the interest rate. Trying to overcome the issue with short-term ineffective methods like buying your own national currency and using the reserve option will make things worse in the long term.

SarahGen
Post 1

Is it possible to restrict the economy without increasing interest rates?

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