Expansionary Monetary Policy

Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Expansionary Monetary Policy?

Monetary policy refers to the central banks’ actions that affect the quantity of money and credit in an economy to influence economic activity. When the money supply’s growth rate increases, banks have more funds to lend, which puts downward pressure on interest rates.

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Expansionary Monetary Policy (wallstreetmojo.com)

Lower interest rates increase investment in plants and equipment because the cost of financing these investments declines. Lower interest rates and greater credit availability will also increase consumers’ spending on consumer durables (automobiles, large appliances) typically purchased on credit. Thus the effect of the expansionary monetary policy is to increase aggregate demand (C=consumption and I=investment increase).

Key Takeaways

  • Expansionary monetary policy helps encourage economic growth by increasing the money supply, lowering interest rates, and increasing aggregate demand.
  • This policy promotes economic growth measured by GDP, i.e., Gross Domestic Product. It is a policy that the Central Bank uses its mechanism to boost the economy. Moreover, the Central Banks mainly use this policy during recessions, when the interest drops and the money supply rises, escalating consumption and investments.
  • The monetary policy is expansionary when the policy is below the neutral rate. The expansionary monetary policy thrives because people and corporations obtain better returns by spending money on equipment, new homes, assets, cars, businesses, and other expenditures that may help move the funds throughout the system, ultimately increasing economic activity.

How Does Expansionary Monetary Policy Work?

The expansionary policy helps encourage economic growth by increasing the money supply, lowering interest rates, and increasing aggregate demandAggregate DemandAggregate Demand is the overall demand for all the goods and the services in a country and is expressed as the total amount of money which is exchanged for such goods and services. It is a relationship between all the things which are bought within the country with their prices.read more. One of the forms of expansionary policyExpansionary PolicyExpansionary policy is an economic policy in which the government increases the money supply in the economy using budgetary tools. It is done by increasing the government spending, cutting the tax rate to increase disposable income etc.read more is monetary policy.

When the policy rate is below the neutral rate, the monetary policy is expansionary. The expansionary monetary policy tools are successful because people and corporations get better returns by spending their money on equipment, new homes, assets, cars, investing in businesses, and other expenditures that help move the funds throughout the system, thus increasing economic activity.

In expansionary monetary policy interest rates fall. The central bank focuses on decreasing the discount rate. With the fall in the discount rate, consumers and businesses can borrow very cheaply. This declining interest rate makes the government bonds and savings accounts less attractive, thus encouraging investors and savers towards risk assets. But if the interest rates are already low, the central bank has the minimal option to cut discount rates. Then the central bank purchases government securities, which are known as quantitative easingQuantitative EasingQuantitative easing (QE) is an advanced monetary policy of central banks to stimulate growth in a stagnant economy by large scale buying of government bonds and other assets.read more. Quantitative Easing helps stimulate the economy by reducing the number of government securities in circulation.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Expansionary Monetary Policy Video

 

Effect

Let us look at the impact of expansionary monetary policy.

These expansionary monetary policy tools acts as the booster for economic growth, measured by GDP, i.e., Gross Domestic Product. It is a policy where the central bank utilizes its tools to help stimulate the economy. The central banks mostly use this policy during recessions, when the interest falls, and the money supply increases, increasing consumption and investments.

If the economy is at potential GDP due to monetary expansion, the real output will only increase in the short run.

Example

A recent example of expansionary monetary policy was during the Great Recession in the United States. When the housing prices reduced, and the economy slowed down significantly, the Federal Reserve started cutting its discount rate from 5.25 in June 2007 to 0% by the end of 2008. The economy is still weak. It started purchasing government securities in January 2009 for a total value of $3.7 trillion. The above example shows the impact of expansionary monetary policy.

Objectives

Advantages

Disadvantages

The followings are the disadvantages of expansionary monetary policy:

Expansionary Monetary Policy Vs Contractionary Monetary Policy

  • The main aim of expansionary policy is to increase the supply of money in the economy but the contractionary policy helps in reducing the money supply.
  • Due to expansionary monetary policy inflation may occur due to decrease in interest rates whereas contractionary policy leads to increase in the interest rates, that results in deflation.
  • Expansionary policy decreases the reserve ratios, whereas contactionary policy will increase the same.
  • The Central bank purchases government securities in expansionary policy whereas in contractionary policy the central bank sells the government securities.

Frequently Asked Questions (FAQs)

What is the lasting effect of expansionary monetary policy?

An expansionary monetary policy brings down the cost of borrowing. Thus, consumers may spend more, while businesses get encouraged to invest more extensive capital.

What is the difference between expansionary and contractionary monetary policy?

Expansionary monetary policies are those that incline the aggregate demand in the economy. Conversely, contractionary economic policies decline the aggregate demand curve in the economy.



How does expansionary monetary policy affect unemployment?

An expansionary monetary policy reduces unemployment due to a higher money supply and fascinating interest rates, which increases business activities and job market expansion.

This has been a guide to what is Expansionary Monetary Policy. We explain it with example, its effects, and differences with contractionary monetary policy. Also, we discuss the advantages and disadvantages of the Expansionary Monetary Policy. You can learn more about economics from the following articles –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *