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.
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).
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- 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.. 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. 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.. Quantitative Easing helps stimulate the economy by reducing the number of government securities in circulation.
Expansionary Monetary Policy Video
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.
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.
- Central banks implement expansionary policy during times of recession to boost growth. With expansionary monetary policy interest rates are lowered, and the money supply is increased. These eventually increase aggregate demand (C=consumption and I=investment increase). As a result, consumers and corporations can borrow money quickly, helping them ultimately to spend more money.
- When the consumers spend more, the businesses have increased revenues and profits. It helps the businesses update plants and equipment assetsPlants And Equipment AssetsPlant Assets are the long-term fixed assets which contribute to a Company’s revenue production for more than a year, like Land Improvements, Machinery & Equipment, Furniture & Fixtures etc. and hire 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, increasing revenues to business, resulting in more jobs.
- If the economy is too robust and more money is there, it may result in expansionary monetary policy inflation. Due to excess cash in the economy for available goods and services, money may lose its value concerning the purchased products. It is a high price for the limited product since buyers have competition, and the highest-paid price is the winner. The expansionary monetary policy also restricts deflationDeflationDeflation is defined as an economic condition whereby the prices of goods and services go down constantly with the inflation rate turning negative. The situation generally emerges from the contraction of the money supply in the economy. during the recession when there is a shortage of money in circulation, and the companies reduce their prices to do more business.
- Lower interest rates help easy borrowing, encouraging corporations to invest and consumers to spend.
- Lower interest rates are directly related to the lower cost of mortgage interest repayments. It makes available more disposable incomeDisposable IncomeDisposable income is an important mechanism to measure household incomes, and includes all sorts of income such as wages and salaries, retirement income, investment gains. In other words, it is the amount of money left after paying off all the direct taxes. to households and encourages spending.
- Lower interest rates give the option of saving less.
- Interest rates on bonds are reduced, which helps in investment.
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, 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 rateFixed Exchange RateA fixed exchange rate refers to an exchange rate regime where a country’s currency value will be tied with the value of another country’s currency or a major commodity., then a change in interest rate will pressure 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 a loan difficult.
- Commercial banksCommercial BanksA commercial bank refers to a financial institution that provides various financial solutions to the individual customers or small business clients. It facilitates bank deposits, locker service, loans, checking accounts, and different financial products like savings accounts, bank overdrafts, and certificates of deposits. may not follow the base rate cut.
- The banks’ Standard variable rate didn’t reduce as much as the base rate.
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)
An expansionary monetary policy brings down the cost of borrowing. Thus, consumers may spend more, while businesses get encouraged to invest more extensive capital.
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 –