Expansionary Monetary Policy (Objectives, Examples, Disadvantages)

What is Expansionary Monetary Policy?

Let us discuss what expansionary monetary policy means in the macroeconomic sense. The expansionary policy helps in encouraging economic growth by increasing the money supply, lowering interest rates, increasing aggregate demand. One of the forms of expansionary policy is monetary policy.

Monetary policy refers to the central banks’ actions that affect the quantity of money and credit in an economy in order to influence economic activity. When the rate of growth of the money supply is increased, banks have more funds to lend, which puts downward pressure on interest rates. Lower interest rates increase investment in plant and equipment because of the cost of financing these investments declines. Lower interest rates and greater availability of credit will also increase consumers’ spending on consumer durables (automobiles, large appliances) that are typically purchased on credit. Thus the effect of the expansionary monetary policy is to increase aggregate demand (C=consumption and I=investment increase).

Effect on GDP

It is a policy where the central bank utilizes its tools to help in stimulating the economy. This policy acts as the booster for economic growth which is measured by GDP i.e. Gross Domestic Product. This policy is mostly used by the central banks, during recessions, when the interest falls and money supply increases which results in the increase in consumption and investments.

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

Elaborating Expansionary Monetary Policy

In situations of high-interest rates, the central bank focuses on decreasing the discount rate. With the fall in the discount rate, consumers and businesses are able to borrow very cheaply. This decreasing interest rate then makes the government bonds and savings accounts less attractive options thus encouraging the investors and savers towards risk assets. But if the interest rates are already on a low then the central bank has the very little option to cut discount rates. Then the central bank purchases government securities which are known as quantitative easing. Quantitative Easing helps in the stimulation of the economy by reducing the number of government securities in circulation.

Expansionary Monetary Policy Works in the Following Ways

Lower interest rates help in easy borrowing which encourages corporations to invest and consumers to spend.
Lower interest rates are directly related to the lower cost of mortgage interest repayments. This makes available more disposable income to households and encourages spending.
Lower interest rates give the option of saving less.
Interest rates on bonds are reduced which helps in investment.

Objectives of Expansionary Monetary Policy

Expansionary policy is implemented by central banks, during times of recession in order to boost growth. With the use of this method, interest rates are lowered and the supply of money is increased. These eventually results in an increase in aggregate demand (C=consumption and I=investment increase). Consumers and corporations can borrow money easily helping them eventually to spend more money.
When the consumers spend more the businesses have increases revenues and profits. This helps the businesses in updating plants and equipment assets as well as hiring new employees. Since it is easier for companies to borrow money they expand their operations thus reducing unemployment. As more people are employed their spending power increases which increases revenues to business resulting in more jobs.
If the economy is too robust and more money is there then it may lead to inflation. It may happen that due to excess money in the economy for available goods and services money loses its value in relation to the purchased products. The result of this is a high price for the limited product since there is a competition among buyers and the highest paid price is the winner. The expansionary monetary policy also restricts deflation which happens during the recession when there is a shortage of money in circulations and the companies reduce their prices in order to do more business.

Disadvantages of Expansionary Monetary Policy

The followings are the disadvantages of expansionary monetary policy:

Consumption and investment are not solely dependent on interest rates.
If the interest rate is very low then it cannot be reduced more thus making this tool ineffective.
The main problem of monetary policy is time lag which comes into effect after several months.
If there is a fixed exchange rate then a change in interest rate will create pressure on the exchange rate.
If confidence is very low people won’t invest or spend despite lower interest rates.
During the phase of a credit crunch, there may not be sufficient funds with the bank to lend even if the central bank has cut the base rates thus making getting loan difficult.
Commercial banks may not follow the base rate cut.
The banks’ Standard variable rate didn’t reduce as much as the base rate.

Example of Expansionary Monetary Policy

A very recent example of the 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 still being weak, it started purchasing government securities from January 2009 for a total value of $3.7 trillion.

Conclusion

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