Lesson 6 of 8 · All lessons in this module
- What central banks do and what they aim for
- The three tools: open market operations, policy rate, reserve requirements
- How a rate change reaches growth, inflation and the currencyVideo lesson
- Effective central banks and inflation targeting
- Exchange rate targeting and policy in developing economies
- Expansionary or contractionary? The neutral rate and the source of shocks
- Limits of monetary policy: weak transmission, deflation and quantitative easingVideo lesson
- How monetary and fiscal policy interact
Lesson 6 of 8 · 12 min
Expansionary or contractionary? The neutral rate and the source of shocks
Policy is contractionary when the policy rate is above the neutral rate (trend real growth plus expected inflation) and expansionary when below it, but before acting the central bank must ask whether rising inflation comes from demand or from supply.
In short
- Contractionary policy raises rates (or drains liquidity) to slow money growth and the economy; expansionary policy cuts rates to boost them.
- The benchmark is the neutral rate of interest: the rate that neither spurs nor slows the economy, consistent with stable inflation.
- Neutral rate = real trend growth + long-run expected inflation (often the inflation target).
- Policy rate above neutral → contractionary; below → expansionary.
- Estimating the neutral rate is more art than science, so analysts can disagree about the stance.
- Demand shock pushing inflation up → tightening fits. Supply shock (e.g. oil price jump) → tightening may deepen a downturn.
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