Expansionary Monetary Policy

What is an Expansionary Monetary Policy?

An expansionary monetary policy is a type of macroeconomic monetary policy that aims to increase the rate of monetary expansion to stimulate the growth of a domestic economy. The economic growth must be supported by additional money supply. The money injection boosts consumer spending, as well as increases capital investments by businesses.

An expansionary monetary policy is generally undertaken by a central bank or a similar regulatory authority.

Tools for an Expansionary Monetary Policy

Similar to a contractionary monetary policy, an expansionary monetary policy is primarily implemented through interest rates, reserve requirements, and open market operations. The expansionary policy uses the tools in the following way:

1. Lower the short-term interest rates

The adjustments to short-term interest rates are the main monetary policy tool for a central bank. Commercial banks can usually take out short-term loans from the central bank to meet their liquidity shortages. In return for the loans, the central bank charges a short-term interest rate. By decreasing the short-term interest rates, the central bank reduces the cost of borrowing to commercial banks.

Subsequently, the banks lower the interest rates they charge their consumers for loans. Therefore, whenever the central bank lowers interest rates, the money supply in the economy increases.

2. Reduce the reserve requirements

Commercial banks are obliged to hold a minimum amount of reserves with a central bank. In order to increase the money supply, the central bank may reduce reserve requirements. In such a case, commercial banks would have extra funds to be lent out to their clients.

3. Expand open market operations (buy securities)

The central bank may also use open market operations with government-issued securities to affect the money supply in the economy. It may decide to buy large amounts of the government-issued securities (e.g., government bonds) from institutional investors to inject additional cash into the domestic economy.

Effects of an Expansionary Monetary Policy

An expansionary monetary policy can bring some fundamental changes to the economy. The following effects are the most common:

1. Stimulation of economic growth

An expansionary monetary policy reduces the cost of borrowing. Therefore, consumers tend to spend more while businesses are encouraged to make larger capital investments.

2. Increased inflation

The injection of additional money into the economy increases inflation levels. It can be both advantageous and disadvantageous to the economy. The excessive increase in the money supply may result in unsustainable inflation levels. On the other hand, the inflation increase may prevent possible deflation, which can be more damaging than reasonable inflation.

3. Currency devaluation

The higher money supply reduces the value of the local currency. The devaluation is beneficial to the economy’s export ability because exports become cheaper and more attractive to foreign countries.

4. Decreased unemployment

The stimulation of capital investments creates additional jobs in the economy. Therefore, an expansionary monetary policy generally reduces unemployment.

Related Readings

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)® certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

• Gross National Product (GNP)
• Inelastic Demand
• Market Economy
• Quantity Theory of Money
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