Expansionary Policy

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What is an 'Expansionary Policy'

An expansionary policy is a macroeconomic policy that seeks to expand the money supply to encourage economic growth or combat inflationary price increases. One form of expansionary policy is fiscal policy, which comes in the form of tax cuts, transfer payments, rebates and increased government spending. Another form is monetary policy, which is enacted by central banks and comes about through open market operations, reserve requirements and interest rates.

BREAKING DOWN 'Expansionary Policy'

The most common form of expansionary policy is the implementation of monetary policy. The U.S. Federal Reserve employs expansionary policies whenever it lowers the benchmark federal funds rate or discount rate, decreases required reserves for banks, or buys Treasury bonds on the open market.

For example, when the benchmark federal funds rate is lowered, the cost of borrowing from the central bank decreases, giving banks greater access to cash that can be lent in the market. When reserve requirements decline, it allows banks to lend a higher proportion of their capital to consumers and businesses. When the government purchases debt instruments, it injects capital directly into the economy.

From a fiscal perspective, the government enacts expansionary policies through budgeting tools that provide people with more money. For example, it can increase discretionary government spending, infusing the economy with more money through government contracts. Additionally, it can cut taxes and leave a greater amount of money in the hands of the people.

The Risks of Expansionary Monetary Policy

Expansionary policy is a useful tool for managing low-growth periods in the business cycle, but it also comes with risks. Economists must know when to expand the money supply to avoid causing side effects, such as high inflation. There is also a time lag between when a policy move is made and when it works its way through the economy. This makes up-to-the-minute analysis nearly impossible, even for the most seasoned economists. Prudent central bankers and legislators must know when to halt money supply growth or even reverse course and switch to a contractionary policy.

An Example of Expansionary Policy

Declining oil prices from 2014 through the second quarter of 2016 have caused many economies to slow down. Canada was hit specifically hard in the first half of 2016, with almost one-third of its entire economy based in the energy sector. This has caused bank profits to decline, making Canadian banks vulnerable to a recession. To combat these low oil prices, Canada is expected to enact an expansionary monetary policy by reducing interest rates within the country.

The expansionary policy should boost economic growth domestically. However, it might also decrease net interest margins for Canadian banks, squeezing bank profits.