What’s it: An expansionary monetary policy is a monetary policy aiming to increase the economy’s money supply. The increased money supply should stimulate economic growth through aggregate demand. The injection of money stimulates consumer spending and capital investment by businesses. The price level (inflation) is slowly moving upward.
More robust demand encourages businesses to increase production. At first, they will increase the overtime hours. When demand gets more robust, they then recruit more workers and invest in capital goods. As a result, aggregate output (real GDP) increases, and the unemployment rate falls.
We also call expansionary monetary policy a loose monetary policy.
How expansionary monetary policy works
Monetary policy works through its influence on aggregate demand. Aggregate demand is the sum of household consumption, business investment, government spending, and imports. Monetary policy usually focuses on the first two elements, namely consumption and investment.
The central bank or monetary authority is responsible for monetary policy in a country. Three main tools for carrying out monetary policy:
- Policy rate or benchmark rate: the central bank’s interest rate for short-term loans to commercial banks.
- Reserve requirement ratio: the portion of deposits held as reserves and cannot be used to make loans.
- Open market operation: selling and buying government securities by the central bank.
Central banks combine these three tools into two types of monetary policy:
- Expansionary policy
- Contractionary policy
All three affect the economy through their effect on the money supply, which in turn has an effect on aggregate demand.
The contractionary policy seeks to reduce high inflation and moderate economic growth. Meanwhile, expansionary policies seek to stimulate economic growth and inflation, usually during a weak economy such as a recession.
The central bank implements expansionary policies with the following three options:
- Cutting policy rates
- Lowering the reserve requirement ratio
- Open market operations through the purchase of government securities
Short-term interest rate adjustments are the central bank’s primary monetary policy tool. You may often hear about it through online media. For example, the Federal Reserve lowered the fed fund rate (FFR) by 100 basis points to 0.25% in March 2020. Bank Indonesia also took similar steps during this period and cut the BI 7-Day Repo Rate by 25 basis points to 4.50%. Both are central bank rates for short-term borrowings.
Commercial banks usually take out loans from central banks to meet their liquidity shortages. As compensation, the central bank charges interest rates. Thus, changes in policy interest rates ultimately affect bank behavior in making loans.
To carry out expansionary monetary policy, the central bank lowers the benchmark rate. Commercial banks bear lower borrowing costs. They hand over less money to pay interest to the central bank.
As a consequence, they have more money to lend to the household and business sectors. Lower borrowing costs to the central bank also pushed down lending rates in the two sectors. This, in turn, increases the credit’s availability in the economy.
Lower interest rates stimulate households to apply for new loans. They use it to buy some durable goods. As a result, household consumption increases.
On the other hand, businesses also take advantage of low-interest rates for capital investment. Initially, they will likely buy some light equipment to increase efficiency. When demand becomes more robust, they then purchase heavier equipment to increase production.
Higher household consumption and business investment stimulate aggregate demand to increase. Slowly, the economy is moving out of recession and heading for an expansion path.
Reserve requirement ratio
Commercial banks must have minimum reserves at the central bank and their own vaults. It is essential as a cushion against risk.
Of the total deposits, commercial banks do not use all of them to make loans. They set aside a certain percentage of deposits as reserves, according to central bank policy. Say, the central bank sets a reserve requirement ratio of around 10%. In that case, the commercial bank must keep $10 out of every $100 saved as a reserve. The rest, $90, they use as a loan.
For example, to increase the money supply, the central bank decreases the ratio to 5%. That means the bank can use $95 to make a loan and set aside $5 as a reserve. As a result, commercial banks now have more money to lend. The extra money will eventually be doubled through the multiplier effect of money.
More money in circulation increases liquidity in the economy. That pushes lending rates down. It is easier for households and businesses to find new, cheaper loans. This, in turn, encourages them to increase their consumption and investment.
Open market operations
Under the expansionary monetary policy, the central bank buys government securities from commercial banks. Securities change hands from commercial banks to central banks. As compensation, the commercial bank receives some payments.
Banks now have more money to lend. As it circulates in the economy, the money will multiply, increasing liquidity and pushing interest rates down. Cheap loans are more readily available, encouraging households and businesses to apply for loans.
Impacts of expansionary monetary policy
The expansionary monetary policy encourages an increase in aggregate demand. When aggregate demand increases, it stimulates businesses to increase production and recruit more workers. As a result, the economy grows, inflation rises, and the unemployment rate falls.
Stimulating economic growth
Increased money supply lowers interest rates and borrowing costs. It stimulates households to spend more, especially on durable goods like property and cars.
On the other hand, investment costs are cheaper for businesses when interest rates fall. Combined with strengthening household demand, they are slowly increasing production.
Initially, some businesses will increase overtime hours. They also prefer to invest in light equipment to increase efficiency. They will see further demand trends before making investment decisions in heavy equipment such as machinery or building new factories.
If aggregate demand becomes stronger, the prospects for future profits improve. Businesses are confident of increasing production by purchasing new machines. As a result, aggregate demand increases, stimulating growth in aggregate output and real GDP, leading to economic growth.
Increasing inflation rate
Extra money injection into the economy raises the inflation rate. It can be both favorable and unfavorable for the economy.
From the quantitative theory of money, an increase in the money supply has consequences for inflation and aggregate output. Specifically, under this theory, economists relate the money supply and circulation, aggregate output, and the price level (inflation) into the following equation:
M x V = P x Y
- M: The money supply
- V: The velocity of money, namely the number of times the same money changes hands during a year.
- P = Price level (inflation)
- Y = Aggregate output
In the short run, economists assume the velocity of money is constant. Thus, when the money supply increases, it results in two possibilities: an increase in the price level and an aggregate output.
If aggregate output increases at the same relative percentage, then the effect of the increase in the money supply on inflation is relatively controllable. This is the ideal outcome of expansionary monetary policy.
However, if the central bank adopts an overly aggressive policy, the money supply increases dramatically. If the aggregate output does not increase at the same pace, the economy faces high inflationary pressure.
Increased money supply raises the supply of domestic currency. It leads to the weakened price of the domestic currency against foreign currencies (depreciation).
Depreciation should encourage exports because the prices of domestic goods are lower in foreign markets. On the other side, the price of imported goods becomes more expensive.
The increase in exports and the decrease in imports stimulate domestic economic growth, as measured by real GDP growth.
To understand this, recall the concept of calculating GDP using the expenditure approach. In brief, economists formulate real GDP as follows:
GDP = Consumption + Business investment + Government spending + (Exports-Imports)
Decreasing unemployment rate
As I explained earlier, at the beginning of the implementation of expansionary monetary policy, the unemployment rate may still be high. Businesses will look at the demand and profit prospects before hiring any new workers.
Suppose companies see the prospect of strong demand and profit. In that case, they will increase output through investment in capital goods and the recruitment of workers. Increased production activity creates more jobs in the economy. From capital investment such as purchasing machinery and production vehicles, businesses need more workers to operate these assets. So, slowly, the unemployment rate falls.