Expansionary Monetary Policy

Definition

Expansionary monetary policy refers to the actions taken by a central bank to increase the money supply and stimulate economic growth. This policy aims to lower interest rates, encourage borrowing and spending, and ultimately boost aggregate demand in the economy.

5 Must Know Facts For Your Next Test

1. Expansionary monetary policy is used to combat economic recessions and stagnation, as it aims to increase economic activity and employment.
2. The central bank can implement expansionary policy by lowering the federal funds rate, which is the interest rate at which banks lend to each other overnight.
3. Lowering interest rates makes it cheaper for businesses and consumers to borrow money, encouraging investment, consumption, and overall economic growth.
4. Expansionary policy can also involve the central bank purchasing government bonds and other securities, a process known as quantitative easing (QE), to inject more money into the financial system.
5. Increased money supply and lower interest rates under expansionary policy can lead to higher inflation, which the central bank must balance against the goal of stimulating the economy.

Review Questions

• Explain how expansionary monetary policy relates to the concepts of microeconomics and macroeconomics.
  • Expansionary monetary policy is a macroeconomic tool used by central banks to influence the overall economy. By increasing the money supply and lowering interest rates, it aims to stimulate aggregate demand, which is a key macroeconomic concept. However, the effects of this policy can also be observed at the microeconomic level, as lower interest rates make it cheaper for businesses and consumers to borrow and invest, ultimately impacting the decisions and behaviors of individual economic agents.
• Describe how expansionary monetary policy relates to Keynes' Law and Say's Law in the AD/AS model.
  • Expansionary monetary policy is closely tied to Keynes' Law, which states that aggregate demand determines the level of economic output. By increasing the money supply and lowering interest rates, expansionary policy aims to boost aggregate demand, leading to increased production and employment. This contrasts with Say's Law, which suggests that supply creates its own demand. In the AD/AS model, expansionary monetary policy shifts the aggregate demand curve to the right, leading to a new equilibrium with higher output and potentially higher prices, depending on the responsiveness of aggregate supply.
• Analyze how a central bank executes expansionary monetary policy and the potential economic outcomes of this policy.
  • To execute expansionary monetary policy, a central bank can lower the federal funds rate, the key interest rate it controls. This makes it cheaper for banks to borrow and lend, encouraging more investment and spending by businesses and consumers. The central bank can also engage in quantitative easing, where it purchases government securities and other assets to inject more money into the financial system. These actions are intended to stimulate aggregate demand, leading to increased economic growth, lower unemployment, and potentially higher inflation. However, the central bank must carefully balance its objectives and monitor the potential risks associated with expansionary policy, such as the potential for overheating the economy and fueling excessive inflation.

Related terms

Contractionary Monetary Policy: The opposite of expansionary monetary policy, contractionary policy involves actions to decrease the money supply and curb economic growth, typically by raising interest rates.

Aggregate Demand (AD): The total demand for all goods and services in an economy at a given price level and time period.

Quantitative Easing (QE): An unconventional monetary policy tool where a central bank purchases government securities or other financial assets to increase the money supply and stimulate the economy.