Monetary policy is based on the relationship between money supply and interest rates, where the interest rate is the price of money. The interest rate, therefore, has an inverse relationship with the money supply. As a result, as the money supply in an economy is decreased, the interest rate is assumed to increase and if the money supply is increased, interest rates are typically assumed to decrease .
Contractionary monetary policy
Contractionary monetary policy results in a reduction in the money supply, depicted as a leftward shift, which results in an increase in interest rates as well as a decrease in the quantity of loanable funds.
The money supply is a monetary policy mechanism available to a central bank as part of its initiatives to promote economic growth and maintain full employment. Central banks use monetary policy to stabilize the economy; during periods of economic slowing central banks initiate expansionary policy, whereby the bank increases the money supply in order to lower prevailing interest rates. As the cost of money falls, economic theory assumes that the demand for funds will increase, thereby expanding consumer and investment spending and promoting economic growth. During periods where the economy is showing signs of growing too quickly or operating above full employment, the central bank may initiate a contractionary or restrictive monetary policy by reducing the money supply and allowing interest rates to increase and economic growth to slow.
Restrictive policy
An active contractionary policy restricts the size of the money supply, increasing the interest rate. Central banks can decrease the money supply through open market operations and changes in the reserve requirement.
Bank reserves
Banks and other depository institutions keep a certain amount of funds in reserve to meet unexpected outflows. Banks can keep these reserves as cash in their vaults or as deposits with the Fed. By adjusting the reserve requirement, the Fed can effectively change the availability of loanable funds.
In a contractionary policy regime, the Fed would increase the reserve requirement, thereby effectively restricting the funds that banks have available for loans.
Federal funds market
From day to day, the amount of reserves a bank wants to hold may change as its deposits and transactions change. When a bank needs additional reserves on a short-term basis, it can borrow them from other banks that happen to have more reserves than they need. These loans take place in a private financial market called the federal funds market.
The interest rate on the overnight borrowing of reserves is called the federal funds rate or simply the "funds rate." It adjusts to balance the supply of and demand for reserves. For example, if the supply of reserves in the fed funds market is lower than the demand, then the funds rate increases.
At higher fed funds rates, banks are more likely to limit borrowing and their provision of loanable funds, thereby decreasing access to loanable funds and reducing economic growth.
Restrictive monetary policy will seek to increase the fed funds target rate. The Fed does not control this rate directly but does control the interest rate indirectly through open market operations.
Open market operations
The major tool the Fed uses to affect the supply of reserves in the banking system is open market operations—that is, the Fed buys and sells government securities on the open market. These operations are conducted by the Federal Reserve Bank of New York.
In a contractionary policy regime, the Fed sells government securities from a bank in exchange for cash. Payment for the bonds decreases the bank's reserves, reducing the supply of funds that the bank has for loans. The Fed's open market purchase decreases the supply of reserves (money) to the banking system, and the federal funds rate (interest rate) increases. In net, this reduces the financial resources available to stimulate growth and leads to a contraction in the economy.