Expansionary Monetary Policy: What It Is and How It Works

What is an Expansionary Monetary Policy?

Expansionary monetary policy is a type of economic policy that aims to increase the rate of money supply to stimulate economic growth.

A country’s central bank can enact expansionary monetary policy by lowering interest rates, reducing bank reserve requirements, and buying government securities. The goal is to make borrowing more affordable, encouraging consumer spending and business investment, which, in turn, boosts economic activity and creates jobs.

When Do Central Banks Use Expansionary Monetary Policy?

Central banks implement expansionary monetary policy during economic downturns or recessions when growth slows and unemployment rises. This macroeconomic policy aims to prevent prolonged or worsening economic stagnation by making credit more accessible and affordable.

For example, the Federal Reserve used aggressive expansionary measures during the 2008 financial crisis and the 2020 pandemic recession. Both cases required injecting money into the economy to restore lending activity and consumer confidence.

Tools for an Expansionary Monetary Policy

An expansionary monetary policy is primarily implemented through interest rates, reserve requirements, and open market operations. 

Central banks implement these three expansionary policy tools in the following ways:

1. Lower the short-term interest rates

Lowering short-term interest rates is the central bank’s primary monetary policy tool.

When commercial banks borrow from the central bank to meet cash shortages, they pay interest on these loans. By reducing these interest rates, the central bank lowers the cost of borrowing for commercial banks.

Banks then pass these savings to consumers through lower loan rates. This makes mortgages, car loans, and business loans more affordable, increasing spending throughout the economy.

2. Reduce bank reserve requirements

Commercial banks are obliged to hold a minimum amount of reserves with a central bank. To increase the money supply, the central bank may reduce reserve requirements. With lower reserve requirements, commercial banks have extra funds to lend out to their clients. 

This additional lending puts more money into circulation throughout the economy. 

3. Expand open market operations (buy securities)

The central bank might use open market operations with government-issued securities to affect the money supply in the economy. Open market operations mean the central bank buys large amounts of government-issued securities, such as government bonds, from large investors like pension funds and investment firms.  

Buying back government securities is another way to inject additional cash into the domestic economy. Open market operations also indirectly affect interest rates. When central banks purchase government securities, yields on these securities fall.

Effects of an Expansionary Monetary Policy

An expansionary monetary policy can bring fundamental changes to the economy, including economic growth and increased inflation

1. Stimulation of economic growth

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

This increased economic activity creates a multiplier effect throughout the economy. More spending leads to higher production, which creates more jobs and further increases spending power.

2. Decreased unemployment

Lowering the cost of borrowing stimulates capital investments, which can lead to businesses creating additional jobs in the economy. When businesses can borrow money more cheaply, they expand operations and hire more workers. Therefore, an expansionary monetary policy generally reduces unemployment. 

3. Increased inflation

The injection of additional money into the economy increases inflation levels. This 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, moderate inflation can prevent deflation (falling prices). 

Deflation can cause more damage than reasonable inflation because it discourages spending and investment. When consumers expect prices to fall, they delay purchases, which slows economic growth. 

4. 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.

However, currency devaluation also makes imports more expensive. This creates trade-offs that central banks must carefully consider.

Expansionary vs. Contractionary Monetary Policy

Expansionary and contractionary monetary policies serve opposite purposes. Expansionary policy stimulates growth during recessions by increasing money supply and lowering rates. Contractionary policy controls inflation during overheated economies by decreasing money supply and raising rates.

Central banks shift between these policies based on economic conditions. During the 2008 financial crisis, the US Federal Reserve used expansionary policy to boost lending and economic activity. In contrast, throughout 2022-2023, the Fed used contractionary policy to combat high inflation.

The choice between these policies depends on whether the economy needs stimulation or cooling. Central banks monitor indicators like GDP growth, unemployment rates, and inflation levels to determine which approach is appropriate.

The Bottom Line

Expansionary monetary policy helps central banks stimulate economic growth by increasing the money supply. This economic policy uses three main levers: lowering interest rates, reducing bank reserve requirements, and purchasing government securities. 

This approach is typically effective in combating recessions and reducing unemployment by making borrowing more affordable for consumers and businesses. 

However, central banks must balance economic stimulus against risks like high inflation and currency devaluation. Understanding these mechanisms helps finance professionals anticipate market conditions and make informed investment decisions.

Frequently Asked Questions

What is the main goal of expansionary monetary policy?

The primary goal of expansionary monetary policy is to stimulate economic growth by increasing the money supply, making borrowing cheaper, and encouraging spending and investment. Central banks use this policy to combat recessions and high unemployment.

How does expansionary monetary policy affect interest rates​?

Periods of expansionary monetary policy typically see lower interest rates, making borrowing cheaper. Central banks reduce the rates they charge commercial banks, who then pass lower rates to consumers and businesses. 

Lower borrowing costs typically encourage more loans for business investments, which stimulates economic activity.

Does expansionary monetary policy cause inflation?

Expansionary policy typically increases inflation because it adds more money to the economy. However, moderate inflation can be beneficial by preventing deflation, which damages economic growth. The challenge for central banks is avoiding excessive inflation that reduces purchasing power and economic stability.

How does expansionary monetary policy affect unemployment​?

Expansionary policy typically reduces unemployment by making borrowing cheaper for businesses. When companies can access affordable credit, they invest in expansion and hire more workers. This job creation was a key objective of central banks during the 2008 financial crisis and the 2020 pandemic responses.

Additional Resources

CFI is the official provider of the global Capital Markets & Securities Analyst (CMSA®) 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
• Vasicek Interest Rate Model
• See all Economics resources