There are several actions that a central bank can take that are expansionary monetary policies. Monetary policies are actions taken to affect the economy of a country. The key steps used by a central bank to expand the economy include:
- Decreasing the discount rate.
- Purchasing government securities.
- Reducing the reserve ratio.
All of these options have the same purpose—to expand the supply of currency or money supply for the country.
- A central bank, such as the Federal Reserve in the U.S., will use expansionary monetary to strengthen an economy.
- The three key actions by the Fed to expand the economy include a decreased discount rate, buying government securities, and lowered reserve ratio.
- One of the greatest examples of expansionary monetary policy happened in the 1980s.
- The Fed also implanted an expansionary policy during the 2000s following the Great Recession, lowering interest rates and utilizing quantitative easing.
Stimulating Monetary Policies
The central bank will often use policy to stimulate the economy during a recession or in anticipation of a recession. Expanding the money supply results in lower interest rates and borrowing costs, with the goal to boost consumption and investment.
When interest rates are already high, the central bank focuses on lowering the discount rate. As this rate falls, corporations and consumers can borrow more cheaply. The declining interest rate makes government bonds, and savings accounts less attractive, encouraging investors and savers toward risk assets.
When interest rates are already low, there is less room for the central bank to cut discount rates. In this case, central banks purchase government securities. This is known as quantitative easing (QE).
QE stimulates the economy by reducing the number of government securities in circulation. The increase of money relative to a decrease in securities creates more demand for existing securities, lowering interest rates, and encouraging risk-taking.
A reserve ratio is a tool used by central banks to increase loan activity. During recessions, banks are less likely to loan money, and consumers are less likely to pursue loans due to economic uncertainty. The central bank seeks to encourage increased lending by banks by decreasing the reserve ratio, which is essentially the amount of capital a commercial bank needs to hold onto when making loans.
Example of Monetary Policy Implementation
The most widely recognized successful implementation of monetary policy in the U.S. occurred in 1982 during the anti-inflationary recession caused by the Federal Reserve under the guidance of Paul Volcker.
The U.S. economy of the late 1970s was experiencing rising inflation and rising unemployment. This phenomenon, called stagflation, had been previously considered impossible under Keynesian economic theory and the now-defunct Phillips Curve. By 1978, Volcker worried that the Federal Reserve was keeping the interest rates too low and had them raised to 9%. Still, inflation persisted.
Volcker stayed the course and continued to fight inflationary pressures by increasing interest rates. By June 1981, the fed funds rate rose to 20%, and the prime rate rose to 21.5%. Inflation, which peaked at 13.5% that same year, crashed all the way to 3.2% by mid-1983.
The rising rates were a shock to the capital structure in the economy. Many companies had to renegotiate their debts and cut costs. Banks called in loans, and total spending and lending dropped dramatically. During this reorganization, the level of unemployment in the U.S. rose to over 10% for the first time since the Great Depression. However, the monetary policy objective of lowering inflation seemed to have been met.
A more recent example of expansionary monetary policy was seen in the U.S. in the late 2000s during the Great Recession. As housing prices began to drop and the economy slowed, the Federal Reserve began cutting its discount rate from 5.25% in June 2007 all the way down to 0% by the end of 2008. With the economy still weak, it embarked on purchases of government securities from January 2009 until August 2014, for a total of $3.7 trillion.