Definition
Contractionary policy is a deliberate effort by government or a central bank to cool down an economy that is growing too fast or generating excessive inflation. It works by reducing aggregate demand, the total spending on goods and services across the economy.
On the monetary side, a central bank tightens by raising interest rates, selling bonds, or increasing reserve requirements. On the fiscal side, a government tightens by cutting spending or raising taxes. Both approaches shrink the flow of money chasing available goods, which puts downward pressure on prices.
Why it matters
How it works
When a central bank raises its policy rate, loans for homes, cars, and business expansion become more expensive. Households and firms borrow and spend less, demand falls, and inflation eases. Fiscal contraction does the same by removing government demand directly or by leaving households with less after-tax income. The effect is not instant, so policymakers must anticipate where the economy is headed rather than react to current data alone.