Definition of restrictive monetary policy
What is a restrictive monetary policy?
A restrictive monetary policy is a set of central bank measures aimed at combating an inflation rate that is too high. The objective is therefore to stop devaluation of the currency on the foreign exchange market and restore economic agents’ confidence in this currency. A restrictive monetary policy is adopted in times of strong economic growth, in times of overheating. It has the effect of reducing the money supply in circulation.
Restrictive monetary policy instruments
The main instrument available to the central bank to implement a restrictive monetary policy is raising policy rates. This has the effect of slowing down the granting of credit to economic agents, as the cost of credit is higher. It is therefore a way to slow down the expansion of the money supply and thus to fight inflation.
To undertake a restrictive monetary policy, the central bank can also increase the reserve requirement ratio. As a result, commercial banks must deposit a larger proportion of their deposits with the central bank. Commercial banks can then grant less credit to economic agents.
The central bank may also use open market operations, which are non-conventional restrictive monetary policy measures. The operation consists in massively selling securities (treasury bills, bonds, etc.) on the interbank market to flood the market with securities and thus increase long-term interest rates.
Risk of a restrictive monetary policy
A restrictive monetary policy can work too well and lead to a slowdown in economic activity or even a recession. Effectively, if the increase in interest rates is too high it can lead to a sharp fall in household consumption and business investment (rising credit costs). The challenge of a restrictive monetary policy is therefore to find the right mix to stop inflation growth while at the same time not affecting the level of economic activity too much.
The other risk of a restrictive monetary policy is the significant deterioration in the external trade balance. Effectively, if the inflation rate falls, it can lead to strong appreciation of the currency on the foreign exchange market and therefore to lower competitiveness of goods and services abroad. If the country's economic activity is dependent on exports, then economic growth can slow sharply.