Expansionary Monetary Policy

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What is expansionary monetary policy?

Expansionary Monetary Policy is one of the macroeconomic methods (fiscal or monetary policies) used by governments to stimulate an economy positively. It enhances and encourages the economy's growth and boosts financial activities within a given period.

This method is adopted from the Keynesian economics theories, which suggest how demand can be aggregated and how to influence output and the overall growth of an economy. These theories also tap into inflation and its implications and how it can be positive or negative.

One of the main objectives of this policy is to boost demand through monetary policies. Boosting demand implies an increase in the level of purchases of the available products and services by individuals in an economy, positively impacting the suppliers.

This policy is applied to economies that are underperforming or witnessing a wave of possible recession due to low economic activities. Hence, the government and experts need to boost the impacted economy before it is an official recession.

Though conventional, this approach can have financial implications- political downturn, local instability, etc. as this approach is costly. Hence, experts must carefully study these policies' impact before they are adopted.

This approach is also named "loose policy" as it lessens the tights on borrowing money or interest rates. It also increases the money supply to stimulate individuals and entities to spend more and request more of the available products and services in the markets attempting to boost the overall economy.

Slow or mellow economies usually lead to recessions resulting in many implications for parties involved in the economy, starting from individuals to product suppliers and service providers.

Throughout the history of civilizations, experts in trading and markets have tried to understand the elements that directly impact the performance of any economy and how they tweak or stimulate them to ensure a healthy performance by markets for a thriving economy.

Healthy performance is crucial for almost all individuals who are a part of this economy as it will impact their income, services provided by their governments, employment, ability to enjoy life, and other crucial aspects of life.

Key Takeaways

Used to stimulate economic growth, Expansionary Monetary Policy, rooted in Keynesian economics employs tools like interest rate reductions but demands careful consideration due to financial and political implications.
Implemented through open market operations, adjusting the fed funds rate, altering the discount rate, and lowering reserve requirements, these measures increase liquidity and stimulate economic activities.
Expansionary policy carries risks, including high inflation and delayed impacts, requiring policymakers to navigate uncertainties and distributional challenges.
Challenges include low consumer confidence affecting spending and banks' reluctance to pass on rate cuts during credit crunches.

Understanding The Expansionary Monetary Policy

The world’s economy is rapidly shifting from stable to unstable, sometimes robust to fragile. However, one of the certainties about the economy is that it needs stimulation in most scenarios to ensure its equilibrium when possible.

The economy, in general, can not outperform or underperform. It has to be balanced to ensure a healthy status quo.

In some scenarios, the economy needs positive stimulation to revive and create a momentum of economic activities.

One of the good examples of how the Federal Reserve conducts expansionary monetary policy works. The reserve usually uses three tools to boost and enhance economic growth.

1. Open market operations

It is one of the most common tools used by the federal government. It occurs when the Federal purchases Treasury notes from the member banks. But where does the fund for this come from? The Fed merely creates a credit to conduct this activity.

When the Fed purchases Treasury notes from banks, it exchanges credit. Banks utilize this credit to provide more lending opportunities to the public. As a result, banks will reduce lending or interest rates as this credit is an excess.

Hence, loans for vehicles, schools, and home mortgages will cost less and reduce interest rates on credit cards.

Collectively, this will boost public spending and allow more borrowing activities, which translate to increased consumption and financial activities.

2. Fed funds rate

The Federal Open Market Committee can potentially decrease the fed funds rate. It refers to the price that banks charge one another for overnight deposits.

The Fed mandates that banks hold a predetermined portion of their deposits in reserve each night at their neighborhood Federal Reserve branch office. As a result, banks with extra liquidity will lend to banks with insufficient liquidity at the fed funds rate.

When the Fed lowers its target rate, banks can hold reserves for less money, increasing their available funds for lending. Consequently, banks can cut the interest rates they offer clients.

3. Discount rate

The interest rate the Fed charges banks who borrow from its discount window is known as the discount rate.

The Fed is viewed as the lender of the last resort. When banks cannot obtain loans from other banks, banks only employ the discount window. Even though the discount rate is lower than the fed funds rate, banks maintain this position.

The Fed reduces the fed funds rate and lowers the discount rate.

4. Reserve requirement

The fourth tool of the Fed is to reduce the reserve requirement. Since this immediately enhances liquidity, member banks are required to implement numerous new policies and procedures.

Lowering the fed funds rate is significantly simpler and more effective. The Fed developed numerous additional tools for monetary policy during the financial crisis.

Risks of expansionary monetary policy

The expansionary policy is a well-liked instrument for controlling the business cycle's low-growth phases but also carries some hazards. Macroeconomic, microeconomic, and political-economic concerns are among these dangers.

Extensive investigation and significant uncertainty are needed to determine when to start, how much to do, and when to cease expanding policy. Moreover, overexpansion can have negative impacts like high inflation or a hot economy.

Additionally, there is a delay between implementing a policy decision and its impact on the economy.

Even for the most seasoned economists, this makes current analysis practically impossible.

Prudent central bankers and legislators must be aware of when to stop the expansion of the money supply or even change direction and adopt a contractionary policy. This includes doing the opposite of an expansionary policy, such as hiking interest rates.

Even in the best-case scenario, expansionary monetary policies risk creating microeconomic distortions across the entire economy.

In reality, monetary and fiscal policy works by giving new money to individuals, companies, and sectors of the economy, who spend and spread it throughout the rest of the economy.

This indicates that expansionary policy always entails an efficient transfer of wealth and purchasing power from the earlier recipients to the later users of the new money instead of consistently increasing aggregate demand.

An expansionary policy may also be prone to information and incentive issues like any other government program. Politics can undoubtedly influence how the money an expansionary policy injects into the economy is distributed.

Problems like rent-seeking and principal-agent issues frequently arise whenever sizable sums of public funds are at stake. Additionally, an expansionary policy—fiscal or monetary—involves the disbursement of substantial public funds.

Why Expansionary Monetary Policy May Not Work?

Interest rate reductions don't always result in a robust economic recovery. Under certain circumstances, expansionary monetary policy might not succeed. For example, despite decreasing interest rates, consumers may not want to invest or spend if confidence is very low.

When the confidence and trust in the financial system are low, it will take more than a monetary policy to build back this trust. It will require the whole financial system to become more transparent, and the government must show major public steps toward a healthier financial system.

Although the Central Bank has lowered base rates, obtaining a loan from a bank during a credit crunch may still be challenging since banks may not have the cash to lend. In addition, commercial banks might not pass on the base rate cut.

Banks' standard variable rate (SVR) didn't decrease much during the credit crunch as the base rate did. It is dependent on additional aggregate demand factors. Consumer expenditure may increase as a result of an expansionary monetary policy.

Time Dilation Interest rate reductions may not boost spending for up to 18 months. People might, as an illustration, have a two-year fixed-rate mortgage. As a result, they do not notice the effects of the rate reduction until they remortgage.

Example Of Expansionary Monetary Policy

The prime example of an expansionary policy is the response by central banks to the 2008 financial crisis, which saw interest rates cut to almost zero and the implementation of effective stimulus expenditure programs.

It was an attempt to encourage public spending and build trust in the financial system.

The American Recovery and Reinvestment Act and numerous rounds of quantitative easing by the U.S. Federal Reserve were two examples of this in the United States.

In order to strengthen domestic aggregate demand and support the financial system, U.S. policymakers injected trillions of dollars through loans and spending into the American economy.

Example: Several economies slowed down between 2014 and the second quarter of 2016 due to falling oil prices. Since the energy sector accounts for roughly one-third of Canada's GDP, the country was particularly heavily hit in the first half of 2016.

Canada implemented an expansive monetary strategy by lowering interest rates domestically to counteract these low oil prices. The goal of the expansionary policy was to accelerate domestic economic growth.

The approach also resulted in lower net interest margins for Canadian banks, which reduced bank earnings and profits.

Expansionary vs. contractionary monetary policy

The Fed runs the risk of starting inflation if it floods the financial system with liquidity, i.e., when prices increase by more than the Fed's goal inflation rate of 2%. This objective set by the Fed encourages healthy demand. In addition, it maintains inflation rates as desired.

An economy inevitably experiences inflation, and the US aims for an annual inflation rate of 2%. However, the government and central bank apply the brakes as inflation rises above 2 percent, signaling that prices rise more quickly than anticipated.

If that becomes the scenario, the government will apply a contraction approach to put brakes on inflation before it becomes hyperinflation.

When inflation exceeds 2 to 3 percent, problems begin to arise. To avoid future price increases, consumers start stockpiling. This accelerates demand, which drives companies to increase output and employee numbers.

People can spend more thanks to the increased income and increasing demand.

Businesses will occasionally start raising prices when they are aware that they cannot produce enough. Other times, they boost prices as a result of rising costs. Hyperinflation may result if inflation gets out of hand. When that occurs, prices increase by at least 50% per month.

Conclusion

The economy has many elements that need to be monitored and sometimes stimulated because there is always the human element involved. Whether it is a positive or negative behavior, an impact will be shown on the overall economy.

A country's central bank will execute an expansionary monetary policy when the GDP is decreasing and the economy is in a contractionary phase. A reduction in interest rates, a relaxation of the reserve requirement, and an increase in the purchase of government assets are just a few ways the policy can be implemented.

All of these raise the amount of money in an economy, making it easier for people and companies to get loans and encouraging them to spend the extra cash.

When people and businesses buy more, the demand rises, which forces firms to produce more to keep up with the demand. This causes them to spend more money and hire more workers, which lowers the unemployment rate.

Knowing more about financial markets and the impact of our financial behaviors will require knowledge and tools to enable us to understand these economic phenomena and their implications on our daily lives.