Tight Monetary Policy
Tight monetary policy implies the Central Bank (or authority in charge of Monetary Policy) is seeking to reduce the demand for money and limit the pace of economic expansion.
Tight monetary policy will typically be chosen when inflation is above the inflation target or policy makers fear inflation is likely to rise without a tightening of monetary policy.
Tight Monetary policy could involve.
Raising Interest Rates.
For example, the Bank of England would raise the base rate. This base rate tends to effect all the other interest rates in the economy. This is because commercial banks have to borrow from Bank of England, so if the base rate rises, commercial banks tend to put up their own borrowing and saving rates.
Higher interest rates tend to reduce Aggregate Demand because:
- Borrowing becomes more expensive, therefore firms and consumers are discouraged from investing and spending.
- Saving becomes more attractive. Therefore firms and consumers are more likely to keep saving money in the bank rather than spend.
- Reduced Disposable income. Consumers with a variable mortgage will see a rise in monthly mortgage interest payments. Therefore, they will have less income to spend.
- Exchange Rate effect. By raising interest rates, the exchange rate tends to appreciate because of hot money flows taking advantage of better saving rates in that country. An appreciation in the exchange rate will also help reduce inflationary pressure. Imports will be cheaper. Also, there will be less demand for exports, leading to a decline in aggregate demand The decline in competitiveness may encourage firms to be more efficient and cut costs
Open Market Operations
The Central bank can also tighten monetary policy by restricting the supply of money. To do this they can print less money or sell long dated government bonds to the banking sector. By selling bonds, banks see a reduction in liquidity and therefore reduce lending.
A central bank could also raise the minimum reserve ratio. This forces banks to keep more liquidity in banks.
In practise, the above are not used very frequently.
Effectiveness of Tight Monetary Policy
Higher interest rates may not always bring inflation under control.
- There may be time lags, e.g. it can take up to 18months for interest rates to influence the rest of the economy.
- If confidence is very high, people may continue to borrow and spend, despite higher interest rates.
- If there is cost push inflation (e.g. rising oil prices) tight monetary policy may lead to lower economic growth.
- See: Effectiveness of Monetary Policy