Contractionary monetary policy is the use of increased interest rates to cause a left shift in aggregate demand and therefore cause a fall in price level. The Bank of England would increase interest rates, causing the cost of borrowing to increase and the reward for saving to increase. This should discourage spending and encourage saving, which would cause aggregate demand to shift to the left. This is because AD = C + I + G + (X-M) and this would happen after seeing a fall in consumer spending and investment by businesses around the UK.
AD LEFT SHIFT DIAGRAM
The diagram shows that price level falls from PL1 to PL2 which means that we would achieve disinflation to bring the rate of inflation closer to 2% - which is one of the four macroeconomic objectives. This happens because there are lower demand for goods and services and therefore lower strain on businesses. This disinflation is beneficial for the UK economy because it means that people are less worried about increases in prices and cost of living, and it also means that firms don't have to constantly be pressured into increasing wages for staff. Depending on the extent of the hike in interest rates, there will also be a fall in real gdp to fall from y1 to y2 and an increase in unemployment due to the fall in demand for goods and services.
However, a reasonable increase in interest rates can be ineffective if confidence is very high and inflation is already very high. For example, if prices are rising at 4% and interest rates increase to 3%, then real interest rates would be -1% which means it is still more beneficial to borrow money for rational consumers. Also, an increase in interest rates can cause an increase in the exchange rate due to an increase in hot money flows into the economy, with more demand for the pound. This would make exports more expensive and imports cheaper and this could cause the balance of payments to worsen as well.