Expansionary monetary policy


Expansionary monetary policy

In economics, expansionary policies are fiscal policies, like higher spending and tax cuts, that encourage economic growth.[1] In turn, an expansionary monetary policy is monetary policy that seeks to increase the size of the money supply. In most nations, monetary policy is controlled by either a central bank or a finance ministry.

Neoclassical and Keynesian economics significantly differ on the effects and effectiveness of monetary policy on influencing the real economy; there is no clear consensus on how monetary policy affects real economic variables (aggregate output or income, employment). Both economic schools accept that monetary policy affects monetary variables (price levels, interest rates).

Monetary policy relies on a number of tools: monetary base, reserve requirements, discount window lending and interest rates.

Contents

Monetary policy tools

Monetary base

Expansionary policy can be implemented by increasing the money supply relative to the quantity demanded - it will cause the equilibrium rate of interest to fall, all other things being equal.

Reserve requirements

The monetary authority exerts regulatory control over banks. Expansionary policy can be implemented by allowing banks to hold a lower proportion of their total assets in reserve. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By requiring a lower proportion of total assets to be held as liquid cash the Federal Reserve increases the availability of loanable funds. This acts as an increase in the money supply.

Discount window lending

Many central banks or finance ministries have the authority to lend funds to financial institutions within their country. The funds expands the monetary base. By extending new loans the monetary authority can directly increase the size of the money supply. By advertising that the discount window will increase future lending, the monetary authority can also indirectly increase the money supply by raising risk-taking by financial institutions.

After the September 11, 2001 attacks in the United States, the Federal Reserve announced that it would extend discount window loans to any and all financial institutions who requested funds. This had the effect of preventing any panics due to fear of insufficient liquidity.

Interest rates

The expansion of the monetary supply can be achieved indirectly by decreasing the nominal interest rates.

Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In the United States, the Federal Reserve can set the discount rate, as well as achieve the desired federal funds rate by open market operations. These rates have significant effect on other market interest rates, but there is no perfect relationship. In the United States open market operations are a relatively small part of the total volume in the bond market.

In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By decreasing the interest rate(s) under its control, a monetary authority can expand the money supply, because lower interest rates discourage savings and encourage lending. Both of these effects increase the size of the money supply.

Monetary policy and the real economy

As noted above, the relationship between monetary policy and the real economy is uncertain (expansionary monetary policy should not be confused with economic expansion, which is an increase in economic output in the real economy). Any change to the real economy resulting from an expansionary monetary policy is subject to time lags and effects from other economic variables; in addition, there are possible side effects of expansion, including inflation.Recall the ways that the Fed implements expansionary monetary policy. A lower required reserve ratio provides more funds for banks to lend to their customers. If the Fed decides to buy Treasury securities, the supply of loanable funds and the banks’ reserves increase. Finally, banks find it easier to borrow from the Fed and increase their reserves when the discount rate is lower. Expansionary monetary policy shifts the aggregate demand AD curve outward.

See also

References

  1. ^ Sullivan, arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 551. ISBN 0-13-063085-3. http://www.pearsonschool.com/index.cfm?locator=PSZ3R9&PMDbSiteId=2781&PMDbSolutionId=6724&PMDbCategoryId=&PMDbProgramId=12881&level=4. 

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