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Monetary policy is a policy of influencing the economy through changes in the banking system's reserves that influence the money supply and credit availability in the economy. Contractionary monetary policy is monetary policy that tends to raise interest rates and lower income. An example of contractionary monetary policy is the Federal Reserve Board selling bonds- banks buy the bonds and their liquid currency (M1,in this case cash) turns into a less liquid form (M2, in this case the bonds). Contractionary monetary policy is used to decrease the money supply (banks have less in reserve, so they can lend less out), increase the interest rate (supply of money drops, demand stays the same, so price of money, or the interest rate rises), decrease investment (interest rates are higher) and thereby decrease income and output. Inflation can be combatted either with monetary or with fiscal policy. However, contractionary monetary policy works best because the Federal Reserve Board does not have to deal with being popular/unpopular because it does not have to deal with elections. For example, if Congress tried to pass a bill to lower income and raise the interest rate, all those who voted in favor would not be re-elected. However, the Federal Reserve Board can take the necessary (though unpopular) action of contractionary monetary policy to combat the dangers of rampant inflation. Let's look at the advantages and disadvantages of contractionary monetary policy. Advantages include fighting inflation, a potential trade deficit decrease, capital inflow. Disadvantages include risking recession, an increase in unemployment, slower economic growth, short-run political problems, potentially higher interest rates.
Contractionary monterary policy should not be confused with economic contraction. The latter being a reduction in economic output. Both inflationary and deflationary monetary policy can lead to economic contraction (eg stagflation).
Inflation and Deflation are different from Expansion and Contraction.
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