Expansionary Policy

What is an Expansionary Policy?

Expansionary policies are an economic strategy taken by governments or central banks to increase economic growth and overall demand, especially during economic decline or recession.

The government uses budgetary measures like increasing government spending and reducing tax rates to enhance disposable income to address economic slowdowns and recessions.

Expansionary policy involves using either monetary policy, fiscal policy, or both. It is a component of the Keynesian policy recommendation that aims to mitigate the negative impacts of economic cycles by encouraging increased consumer spending and business investments.

Central banks lower interest rates in expansionary monetary policy, making borrowing cheaper for businesses and individuals. These lower interest rates encourage spending and investment as saving becomes less attractive.

Expansionary fiscal policy involves increasing government spending or reducing taxes to increase the money supply in the economy.

Understanding Expansionary Policy

Expansionary policy, rooted in Keynesian economic principles, aims to increase aggregate demand, stimulating overall economic activity, especially during economic downturns.

This approach addresses recessions by addressing the root cause: a lack of aggregate demand.

Increasing aggregate demand can enhance real future output. Keynes believed that unemployment resulted from a lack of overall demand in the economy, as wages were slow to decrease in response to decreased consumer spending.

Expansionary policy involves increasing business investments and consumer spending by increasing money in the economy. This can be achieved through government deficit spending or increased lending to businesses and consumers.

If expansionary policies are not carefully managed, they may have negative consequences and result in an unbalanced situation.

The effective execution of economic policies is not a one-day task; it takes a considerable amount of time to be implemented correctly, assess results, and make necessary adjustments accordingly.

Further, expansionary policies can be broadly categorized into monetary and fiscal policies.

Expansionary Monetary Policy

Expansionary monetary policy operates by increasing the money supply faster than usual or lowering short-term interest rates.

The main objective of expansionary monetary policy is to make borrowing cheaper and encourage spending and investment. 

It aims to boost economic growth by increasing the money liquidity in the market. This leads to higher investments, expanded business operations, and increased consumer spending.

Central banks implement this policy through various tools:

1. Interest Rate Reduction: One of the key methods involves lowering benchmark interest rates. When central banks decrease these rates, borrowing money becomes more affordable for banks.
   • Consequently, businesses and consumers are encouraged to borrow more, leading to increased spending and investments.
2. Open Market Operations: Central banks can purchase government securities in the open market. This injects more money into the banking system, providing banks with additional funds to lend to businesses and individuals. This increased liquidity promotes borrowing and stimulates economic activity.
3. Discount Window Lending: Another approach is when central banks lend money directly to commercial banks at a lower interest rate. By offering these funds at a reduced cost, banks are motivated to borrow more, subsequently lending to businesses and consumers. This process further fuels economic growth.
4. Quantitative Easing: Central banks buy government bonds and mortgage-backed securities from the market. This increases the money supply and lowers long-term interest rates. Lower interest rates make borrowing enticing, encouraging more investments and economic expansion.

Expansionary fiscal policy

Expansionary fiscal policy refers to the deliberate use of increased government spending or reduced taxes to stimulate economic growth. 

The main objective of expansionary fiscal policy is to reduce unemployment. Increased government spending leads to job creation and, thus, economic growth, while tax reductions empower individuals and businesses with more funds, motivating increased spending and investment.

Central banks implement this policy through various tools:

1. Government Spending: The government can spend more on infrastructure projects, education, and healthcare. This leads to job creation and economic stimulation. 

2. Tax Cuts: Tax reductions increase disposable income, particularly for individuals and businesses. People tend to spend more when they have more money; therefore, consumer spending rises. Tax advantages for businesses might also encourage them to expand and create jobs.

3. Transfer Payments: Transfer payments involve direct financial assistance to individuals or groups. Making unemployment benefits last longer or increasing their amount provides a safety net for those affected by economic downturns.

4. Subsidies: Government subsidies are targeted to specific industries or sectors to support their development or competitiveness. Financial aid for businesses encourages investment, job creation, and competitiveness. Additionally, subsidies for Research and Development (R&D) promote innovation and technological advancement.

5. Grants and Aid: Direct grants to local governments support public projects and services, boosting regional economies. While not directly impacting the domestic economy, foreign aid can contribute to global stability, which may indirectly benefit domestic businesses through international trade.

6. Automatic Stabilizers: Features of the tax and social welfare systems can act as automatic stabilizers. Progressive taxation, where higher-income individuals pay a higher percentage of their income in taxes, helps maintain a degree of fiscal stimulus during economic downturns.

• Unemployment insurance automatically adjusting benefits based on economic conditions also contributes to stability.

7. Public-Private Partnerships (PPPs): Public-private partnerships can be used to finance and implement large-scale projects. Governments can undertake infrastructure development and other initiatives more efficiently by leveraging private sector resources and expertise.

Effects of Expansionary Policy

Expansionary policies can have diverse effects on an economy, especially during economic decline or recession. Here are some of the primary consequences:

1. Increased Availability of Credit

Lowering interest rates enhances credit availability, encouraging borrowing and spending among consumers and businesses. Accessible credit prompts higher consumer spending, boosting economic growth.

2. Stimulated Consumer and Business Activity

Expansionary policy stimulates business investment by reducing borrowing costs for capital expenditures. Cheaper borrowing facilitates job creation, leading to an overall increase in employment opportunities.

3. Rising Demand for Goods and Services

Consumers with more disposable income and expanding businesses lead to heightened demand for goods and services. Firms investing in expansion during this period often experience favorable manufacturing conditions, benefiting from a lower cost of capital.

4. Positive Impact on Trade Balance

Expansionary policy can create a more balanced trade system as companies benefit from lower production costs and are more competitive in the global market.

5. Negative Impact

Inflation Concerns Expansionary policy has the potential for inflation. If the increase in the money supply outpaces economic growth, it can lead to rising prices, wages, and input costs.

Inflation erodes purchasing power, potentially offsetting the positive effects of increased income and spending.

Expansionary policies are beneficial for stimulating economic activity and reducing unemployment. However, they require careful management to prevent excessive inflation, ensuring a balanced and sustainable economic growth trajectory.

How Expansionary Policy Is Implemented?

The following provides a summary of how expansionary policies are put into practice.

Expansionary Monetary Policy Implementation

The following summarizes the execution of expansionary monetary policies.

1. Federal Reserve Oversight: The US Federal Reserve assesses economic indicators and provides policy suggestions derived from its analysis. The Federal Open Market Committee (FOMC), a key decision-making body within the Federal Reserve, meets regularly to decide on the federal funds rate, which impacts interest rates in the economy.
2. Policy Implementation Process: Policy decisions are conveyed to financial markets and institutions via official announcements and news releases after making them. Commercial banks vary their lending rates in reaction to changes in the federal funds rate, affecting business and consumer borrowing costs.
3. Market Operations: The Federal Reserve conducts open market operations, i.e., buying and selling government securities to influence the money supply. Purchasing securities injects money into the economy while selling securities absorbs money, regulating liquidity levels.

Expansionary Fiscal Policy Implementation

The following summarizes the execution of expansionary fiscal policies.

1. Government Spending Initiatives: Approved fiscal policies often include increased investment in infrastructure projects, healthcare, education, and technology sectors. Government agencies oversee allocating funds to specific projects, creating jobs, and stimulating economic activity.
2. Taxation Adjustments: Tax cuts are designed to increase disposable income for individuals and stimulate spending. The Internal Revenue Service (IRS) implements changes to tax codes, ensuring that citizens benefit from reduced tax burdens.
3. Monitoring Economic Impact: Economists and policymakers regularly assess how expansionary measures affect GDP growth, employment rates, and consumer spending. They make iterative adjustments based on economic data to ensure the effectiveness of the implemented measures.

Risks of Expansionary Policy

Some of the major risks associated with expansionary policies are as follows:

1. Inflation: Inflation becomes concerning, especially when the economy is close to full capacity. Boosting the money supply or government spending can increase demand, causing prices to rise. A significant increase in inflation undermines the purchasing power of money and may contribute to economic instability.
2. Interest Rates: Lowering interest rates as part of expansionary monetary policies stimulates borrowing and spending, boosting economic activity.
   • However, this approach can result in excessive debt for households and businesses. As interest rates rise, repaying these debts can become challenging, potentially contributing to financial crises.
3. Fiscal Sustainability: While boosting the economy through increased spending or tax cuts is vital in tough times, prolonged deficits and a rising debt-to-GDP ratio could threaten stability. This raises worries about potential future tax hikes or cuts in public services, emphasizing the need for a balanced fiscal strategy.
4. Asset Bubbles: Lower interest rates may inflate asset prices, such as real estate and stocks, potentially leading to asset bubbles. If these bubbles burst, it can result in market crashes and financial instability as prices become detached from their intrinsic values.
5. Exchange Rates: Expansionary policies can influence exchange rates, potentially leading to currency depreciation. While a weaker currency can boost exports, it also makes imports more expensive, contributing to inflationary pressures.
   • Moreover, sudden and significant currency devaluation can lead to market uncertainties and disrupt international trade.
6. Dependency: If the economy becomes overly reliant on expansionary policies to sustain growth, it can create a situation where it struggles to grow without continuous stimulus. This dependency can limit the government's ability to respond effectively to future economic downturns.

Examples of Expansionary Policy

After the 2008 global financial crisis, the United States implemented monetary and fiscal measures to improve the economy.

Monetary Policy

The following is how they implemented monetary measures:

1. Interest Rate Reduction: The Federal Reserve significantly reduced the federal funds rate, reaching nearly zero by December 2008. This move aimed to stimulate borrowing and spending by making the cost of credit more favorable.
2. Quantitative Easing: The Federal Reserve implemented multiple rounds of quantitative easing to enhance economic liquidity. This involved significant government and mortgage-backed securities acquisitions to reduce long-term interest rates and promote increased investment.
3. Forward Guidance: The Federal Reserve provided forward guidance, signaling its commitment to keeping interest rates low for an extended period. This assurance was designed to influence consumer and business expectations, further promoting economic activity.

Fiscal Policy

The following is how they implemented fiscal measures

1. Increased Government Spending: The 2009 American Recovery and Reinvestment Act invested in projects like roads, schools, healthcare, and clean energy, leading to job creation and economic growth.
2. Tax Reliefs: Tax cuts were introduced to help individuals and businesses. Initiatives like the Making Work Pay tax credit aimed to increase disposable income and stimulate spending, while corporate tax cuts sought to enhance after-tax profits and encourage investment.
3. Automatic Stabilizers: Existing programs like unemployment benefits played a role as automatic stabilizers, supporting those who lost jobs. This support helped maintain consumer spending levels during the economic downturn, contributing to economic stability.

Expansionary Policy Vs. Contractionary Policy

Let's compare the above two types of policies commonly set by the monetary authority:

Authored and researched by Rani Thakur⎮LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

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