Expansionary Policy

Expansionary Policy Definition

Expansionary policy is defined as an economic policy during which the government increases the money supply in the economy using budgetary tools like increase government spending, cutting the tax rate to increase disposable income primarily with the objective of tackling economic slowdowns and recession.

Understanding of Expansionary Policy

Expansionary policy boosts the aggregate demand by infusing more money in the economy. Expansion of cash is done by the following methods:

Expansionary-policy

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For eg:
Source: Expansionary Policy (wallstreetmojo.com)

Expansionary Policy Examples

Following are the examples of expansionary policy.

Example #1

U.S congress to develop suitable fiscal policiesFiscal PoliciesFiscal policy is a government policy that is used to control a country's finances and revenue, and it includes various taxes on goods, services, and individuals, i.e., revenue collection. It has an impact on spending levels, so it is referred to as monetary policy's sister policy.read more for the state of Utah which has 3% inflation, 8% unemployment, 1% GDP growth rate and 5% budget surplus. So as an economic advisor to U.S Congress Mr. Adams analyzed that Utah has low inflation, high unemployment, low GDP growth, and high a budget surplusA Budget SurplusA budget surplus occurs when the government's earnings through tax revenues is more than its spending in the current quarter or year. A government surplus is a positive sign in an economy because it demonstrates the government's earning power.read more, this clearly signifies that Utah is currently in the recession phase of the economic cycle and need a boost to reverse the cycle.

So Mr. Adams prepared an expansionary policy in which, seeing the high budget surplus suggested tax cut and also suggested the federal government increase their expenditure in sectors that we increase demand in the market and also create employment opportunities.

Example #2

Another example of the expansionary monetary policy was during the great recession in the USA. When the housing price reduced to a new level and economy was also significantly slow, then the federal reserve started reducing its short term borrowing rate from 5.25% in mid of 2007 to 0% by the end of December 2008. The economy still didn’t reflect any sign of recovery, so federal reserve started purchasing government securities and bonds from Jan 2009 onwards by infusing billions of dollars in the economy.

Tools of Expansionary Policy

Expansionary policy tools as follows –

  1. Reduction in Short-term Interest Rates – All the central banks cut the rates at which commercial banks take loans from them to meet their liquidity shortages. So this gives commercial banks scope to cut down interest rates they charge against the short-term loansShort-term LoansShort term loans are the loans with a repayment period of 12 months or less, generally offered by firms, individuals or entrepreneurs for immediate liquidity requirements. These are usually provided at a higher interest rate, these short term loans often have a weekly repayment schedule.read more.
  2. Reduction in Reserve Requirements – Central banks will reduce the amount that needs to be kept by commercial banks as a reserve, this will provide more liquidity to banks hence leads to an increase in the loanable fund.
  3. Buy-Back of Securities – The government may decide to buy back a large amount of government-issued securities and bonds from Domestic and Institutional investorsInstitutional InvestorsInstitutional investors are entities that pool money from a variety of investors and individuals to create a large sum that is then handed to investment managers who invest it in a variety of assets, shares, and securities. Banks, NBFCs, mutual funds, pension funds, and hedge funds are all examples.read more to infuse more liquid funds in the economy.
  4. Increase in Public Expenditure – The government comes up with various policies and relief packages for different sectors in order to boost the economy and attract more investment.
  5. Tax Cuts – Government with an idea of creating demand by increasing the disposable income cut down the Individual taxes and Business taxes.

Effect of Expansionary Policy

Effects of an expansionary policy on the interest rate and 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 are as follows-

#1 – On Interest Rate

Effect on Interest Rate

Source: Opentextbc.ca

As shown in the figure, the original equilibrium (E0) occurs when borrowing of $10 billion was provided at an interest rate of 8%. An expansionary monetary policy by the government will increase the supply of the fund hence shift the supply of loanable funds to the right from S0 to S1, leading to shifting in equilibrium towards the right to position E1 where more loans are available at a low-interest rate. Vice versa will be the scenario in case of contractionary economic policy that will reduce the cash in the Economy and so reduce the supply of loanable funds that will make borrowing expensive.

#2 – On Aggregate Demand

An expansionary policy increases the number of loanable funds with the banks that lead to a reduction of interest rate and also policy when coupled with the tax rate cut increases the money in the pocket of consumers. More disposable income will increase the purchasing power of the consumers and will create the demand in the market.

Advantage

Given below are the advantages of expansionary policy.

  • Multiplier Effect – More government spending leads to the inflow of more money in the hand of the public and policies like tax rate cut also increase their disposable income, which leads to additional spending and creation of demand and leads to Economic Growth.
  • Increase in Investment – Expansionary Policy means an increase in Government Investment, under this government put money in the downsized and cash-constrained businesses and provide stimulus to the business.  Private investment gradually picks up as fund infusion from the government will stimulate growth in the sector.
  • Decrease in Unemployment – Expansionary Policy leads to an increase in private and public investment which creates a demand in the market. So, in order to meet demand production shifts are increased which leads to more employment generation.

Disadvantages

Given below are the disadvantages of expansionary policy.

  • Increase in Inflation – The inflow of more money in the economy will increase inflation, inflation is good up to some level and if inflow is not monitored properly that can lead to high inflation which can negatively impact the economy.
  • Currency Devaluation – The higher inflow of currency will reduce the value of the currency that can put an additional burden on the import expenditure of the economy.
  • Crowding Out – Expansionary Policy could lead to falling in investment in the private sector because investors generally prefer government debt over corporate debt because they are a safe investment. Under the expansionary policy, the government needs more funds to and so in order to attract investors will issue bonds at a higher interest rate, this will reduce the demand for corporate debt and will hurt the private sector.

Conclusion

Expansionary Policy is the type of macroeconomic policy that is used by the government to push economic growth and increase investment and aggregate demand. It is the remedy given by Keynesian economicsKeynesian EconomicsKeynesian Economics is a theory that relates the total spending with inflation and output in an economy. It suggests that increasing government expenditure and reducing taxes will result in increased market demand and pull up the economy out of depression.read more to be used during the economic slowdown to push the economy out of recession.

This has been a guide to Expansionary Policy and its definition. Here we discuss the examples of the expansionary policy along with its effect on the interest rate and aggregate demand. You can learn more from the following articles –

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