Expansionary Policy

What is Expansionary Policy?

Expansionary policy is a type of macroeconomic policy that is implemented to stimulate the economy and promote economic growth. Expansionary policies are used by central banks in times of economic downturns to reduce the adverse impact on the economy.

Types of Expansionary Policy

There are two main types of expansionary policy – fiscal policy and monetary policy. Expansionary monetary policy focuses on increased money supply, while expansionary fiscal policy revolves around increased investment by the government into the economy.

1. Expansionary Monetary Policy

Expansionary monetary policy aims to spur economic growth through increased liquidity. Increased money supply promotes economic growth. It occurs because corporations and individuals look to capitalize upon the easily available funds by undertaking greater investments, expanding operations, and increasing consumption.

There are different ways central banks can achieve the goal of increased liquidity. One method is to lower lending rates. Central banks provide loans to commercial banks at a particular rate.

When the rate is lowered, there is more demand for funds by the commercial banks and their clients. Lower rates discourage savings and encourage consumption and investment, which promotes economic growth.

A second way through which central banks can increase the money supply is by reducing the reserve requirement imposed on commercial banks. Commercial banks must hold a certain portion of funds they receive in the form of deposits as reserves.

Lower reserve requirements mean that more funds are made available to those looking to borrow.

Central banks also engage in open market operations to increase liquidity. By purchasing securities, such as government bonds in the market, they inject additional funds into the economy.

2. Expansionary Fiscal Policy

Fiscal policies are enacted directly by the government rather than central banks. Governments aim to stimulate the economy by directly engaging in expansionary activities through increased spending.

The increased spending is typically through building infrastructure projects. Other methods, such as transfer payments, tax cuts, and rebates, are aimed at ensuring that funds are available more easily to the public.

Effects of Expansionary Policy

1. Increased money supply – higher consumption and greater economic growth

Expansionary policies increase the availability of funds, which, in turn, leads to increased consumption and greater economic growth. Because companies have more funds available to them, they increase production, which then increases the demand for all factors of production, including human capital.

2. Greater need for human capital – lower unemployment

The greater need for human capital leads to lower unemployment. The lower levels of unemployment lead to a greater demand for products as consumption increases. It leads the economy into a virtuous cycle.

Over time, the increased money supply and the abundance of funds mean that the value of currency drops, and inflation increases. It is important that inflation rates do not go beyond a certain threshold. To ensure that rates are kept within a certain range, contractionary policies may be deployed.

Inflation and interest rates move in the same direction. Expected and actual inflation rates dictate to central banks whether to increase or decrease rates. Low inflation rates indicate to central banks that a rate cut is needed and vice versa.

Some countries adopt a negative interest rate policy. It is implemented to discourage savings and increase consumer spending. Such low or negative rates are aimed at increasing inflation as it promotes increased spending and lower savings.

Risks of Expansionary Policy

1. Overextended debt levels

One of the risks of expansionary policy is debt being overextended. Because funds are readily available, both corporations and individuals move to take advantage of lower rates by incurring greater debt. High levels of debt are not sustainable over a long period and may lead to damaging results if not analyzed carefully.

2. High inflation rates

The most prominent risk associated with an expansionary policy is the risk of high inflation. Central banks have a target inflation level, which is considered ideal for steady inflation growth. The target inflation rate in the US, as noted by the Federal Open Market Committee (FOMC), is 2%.

If unchecked, inflation can spiral out of control and lead to a situation that is called hyperinflation, which can have a severe adverse impact on the economy. In periods of high inflation, prices of items increase faster than wages do, and real wages along with the standard of living falls.

High inflation also means that real interest earned on savings falls rapidly, and the currency will depreciate rapidly. Countries with high inflation rates, such as Venezuela, South Sudan, and Congo, are facing severe economic depressions.

Additional Resources

CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

• Economic Indicators
• Macroeconomic Factor
• Fiscal Policy
• Negative Interest Rate Policy (NIRP)
• See all economics resources