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Expansionary Policy

Updated on January 29, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is An Expansionary Policy?

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

Expansionary-policy

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Expansionary Policy is the type of macroeconomic policy 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.

Key Takeaways

  • Expansionary policy is an economic policy in which the government raises the money supply by utilizing budgetary tools like boosting government spending and reducing the tax rate to increase disposable income, mainly to overcome economic slowdowns and recessions.
  • Short-term interest reduction, reduction in reserve requirements, buy-back of securities, increase in public expenditure, and tax cuts are the tools of expansionary policy.
  • This policy is the remedy provided by Keynesian economics to be used in the economic crisis to shove the economy out of recession

Expansionary Policy Explained

The concept of expansionary policy is related to a set of financial strategies and methods that the central bank of the country or the government can put in force in order to help the economy boost its growth, consumer demand, employment opportunities and overall domestic market, so that it is able to keep up its place at the global level.

This method is commonly implemented during any crisis, economic slowdown or recession, with the aim to help in social and financial upliftment and economic upgradation. It reverses any negative situation or trend and promotes internal stability.

Expansionary policy boosts the aggregate demand by infusing more money into the economy. The following methods do expansion of cash:

However, every government should consider this measure in a very skilled and balanced way. If expansionary policy graph is not handled judiciously, then it can lead to adverse effects and create imbalance. It is also important to note that any economic policy is not a matter of one day. It takes a long time to properly implement them, see the results and make changes accordingly.

Therefore, it is easy to understand that any economic policy should be implemented after a lot of careful consideration because implementation is time consuming and costly. Not only that, there is a continuous need to monitor it and it is difficult to reverse it or make any changes if it does not work as desired.

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Examples

Following are the examples of expansionary policy.

Example #1

U.S congress to develop suitable fiscal policiesFiscal PoliciesFiscal policy refers to government measures utilizing tax revenue and expenditure as a tool to attain economic objectives. read more for 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. It signifies that Utah is currently in the economic cycle’s recession phase and needs a boost to reverse the cycle.

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

Example #2

Another example of the expansionary monetary policyExpansionary Monetary PolicyThe central bank uses expansionary monetary policy to increase the supply of money while lowering the interest rate and increasing demand. This is done to boost a country's economy.read more was during the great recession in the USA. When the housing price was reduced to a new level, and the economy was also significantly slow, 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 the federal reserve started purchasing government securities and bonds from Jan 2009 onwards by infusing billions of dollars into the economy.

Given above are two practical examples where an economy used the expansionary policy graph to boost the economic condition through increase in government expenditure, lowering interest rates and tax cuts. This successfully put more money in the hands of the consumers who started more investments to expand the economic condition. This contributed to growth of the country.

Tools

Expansionary policy tools as follows –

  1. Reduction in Short-term Interest Rates – Central banks cut the rates at which commercial banks take loans from them to meet their liquidity shortages. So expansionary policy interest rates gives commercial banks scope to cut down interest rates they charge against the short-term loansShort-term LoansShort-term loans are defined as borrowings undertaken for a short period to meet immediate monetary requirements.read more.
  2. Reduction in Reserve Requirements – Central banks will reduce the amount needed by commercial banks as a reserve. It will provide more liquidity to banks, leading to an increase in loanable funds.
  3. Buy-Back of Securities – The government may decide to buy back many 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 into the economy.
  4. Increase in Public Expenditure – The government has various policies and relief packages for different sectors 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

Effects of an expansionary policy interest rates 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 shifting 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 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, leads to a reduction of interest rate, and 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 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. Policies like tax rate cuts also increase their disposable income, leading to additional spending and demand and 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 provided 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 increases private and public investment, which creates a demand in the market. So, to meet demand, production shifts are increased, which leads to more employment generation.
  • Business confidence – The open market operations expansionary policy gives a sense of confidence to the consumers as well as the business because when they see that the economy is successfully coming out of the downturn and expanding, they are also motivated to spend and invest more.
  • Control deflation – It helps in controlling deflation where there is a continuous fall in prices of goods and services. This happened when there is not enough money flowing in the economy and people do not have the capacity to make purchases or invest to earn good return. Thus, due to lack of demand prices keep falling and the entire economy has a downturn. Expansionary policy works greatly in such a case.

Disadvantages

Given below are the disadvantages of expansionary policy.

  • Increase in Inflation – The inflow of more money in the economy will increase inflation. If the inflow is not monitored properly, that can lead to high inflation, negatively impacting the economy. Inflation is good up to some level.
  • Currency Devaluation – The higher inflow of currency during open market operations expansionary policy 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 sectorPrivate SectorThe private sector is a section of the national economy that the government does not own. The business conducted under this sector is carried out by companies or entrepreneurs who focus on profit maximization and customer satisfaction.read more 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.
  • Dependency – The concept can create a form of dependency on the process. There may be other ways to get a solution to the economic problems but due to repeated implementation of expansionary policy, the business and even individuals may fail to look at the negative aspect of it and repeatedly take risk during investments and expect to get bailed out.
  • Difficulty in timing – The authority or government should be extra careful to select the time of implementation because if the policy is done too early or too late, there might be imbalance, leading to other problems.
  • Rise in asset prices – In the process, since interest rates are lowered, there is a rise in demand for assets creatin a bubble. If this bubble bursts, it creates a huge financial crisis.

Thus, it is important to evaluate the advantages and disadvantages of the process before implementing it so that helps in growing and expanding the economy successfully.

Expansionary Policy Vs Contractionary Policy

Let u look at the differences between the above two types of policies commonly implemented by monetary authority of an economy.

  • The main aim of the former is to increase economic growth, demand and create job opportunities through investment and expansion. But the aim of the latter is reduce inflation, spending and bring an overall slowdown in economic growth.
  • In the former, there is a fall in interest rates to encourage investment and increase in government spending, where the opposite happens during the latter. There is fall in investment due to rise in interest rates and government curtails the spending policies.
  • There is often tax cust to help people have more money in their hands, whereas for the latter the tax rates are increased to reduce disposable income.
  • The former is typically implemented during economic recession or slowdown ti ive the economy a boost, whereas the latter is implemented when the economy is having high inflation and economic expansion that is not sustainable in the long run.

Frequently Asked Questions (FAQs)



What is a potential adverse effect of an expansionary policy?

For reducing unemployment, the primary expansionary policy’s severe effect is inflation. That is why an increase in the money supply can cause inflation if it outpaces the economy’s growth.

What is an expansionary policy used for?

The expansionary policy aims to expand the company’s investment and consumer spending by driving money into the economy through direct government shortfall spending or increased providers to businesses and consumers.


What are its two central expansionary policies?

There are two main expansionary policy types–fiscal and monetary. Expansionary monetary policy aims at increasing the money supply, while expansionary fiscal policy focuses on increasing investment by the government into the economy.

Why would an expansionary monetary policy no longer be available?

The expansionary monetary policy is no longer available as it would depreciate the country’s exchange rate and cause problematic inflation or recession that must be ignored to focus on the soft peg.

This has been a guide to what is Expansionary Policy. We explain its effects, tools, differences with contractionary policy, examples and advantages. You can learn more from the following articles –

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