Definition: The expansionary monetary policy seeks to increase economic growth by increasing the money supply in the market. Typically, the government steps in with an expansionary monetary policy during a recession.
What Does Expansionary Monetary Policy Mean?
Increasing the money supply increases market liquidity, thereby triggering a higher inflation. To control liquidity, the government increases the demand for securities, causing a decline in the interest rates. The lower interest rates stimulate borrowing and consumer spending because consumers pay lower mortgages and have a higher disposable income. Thus, the aggregate demand increases.
Furthermore, an expansionary monetary policy may pursue quantitative easing, a policy that increases the money supply and lowers the long-term interest rates by allowing the Central Bank to purchase assets from the commercial banks. The main outcome of a quantitative easing is that it boosts cheaper borrowing for banks by lowering the yields on bonds. In turn, the banks can lend to consumers and businesses at lower interest rates.
Let’s look at an example.
The government steps in with expansionary monetary policy when inflation is at 2%, the interest rates at 12%, and the unemployment rate at 9%. By increasing liquidity, the government risks triggering inflation above the 2% target. This target has been set to boost aggregate demand since, if consumers expect that prices will go higher in the future, they will spend more today.
The prospect of a higher inflation causes consumers to spend more today to avoid higher prices later. Therefore, the aggregate demand grows faster, the businesses increase their output, and the unemployment rate declines since more workers are hired. At the same time, the government cuts the interest rates to 5%, thereby stimulating consumer spending and the aggregate demand.
Although inflation is above the 2% target, the general notion is that it won’t last for too long, as it is rather the result of increased liquidity in the market than a fundamental problem of the economy. The FED has to be careful when implementing an expansionary policy because it can devalue the currency permanently if efforts are carried out too long.