What is an Expansionary Policy
Expansionary policy is form of monetary policy that seeks to encourage economic growth by expanding the money supply faster than usual or lowering short-term interest rates. It is enacted by central banks and comes about through open market operations, reserve requirements and setting interest rates.
Expansionary policy differs from fiscal policy, which includes tax cuts, transfer payments, rebates and increased government spending on projects such as infrastructure improvements.
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. Quantitative easing, or QE, is another form of expansionary monetary policy.
BREAKING DOWN Expansionary Policy
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 who then go on to spend and invest.
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, which would involve taking the opposite steps of expansionary policy, such as raising interest rates.
An Example of Expansionary Policy
Declining oil prices from 2014 through the second quarter of 2016 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 was expected to enact an expansionary monetary policy by reducing interest rates within the country. The expansionary policy was targeted to boost economic growth domestically. However, the policy could also have meant a decrease in net interest margins for Canadian banks, squeezing bank profits.
Another example is the policy following the 2008 financial crisis, where central banks around the world lowered interest rates to near zero, and performed other measures such as multiple rounds of quantitative easing. This helped keep the Great Recession from turning into a full-blown economic depression and helped along the albeit slow recovery that followed.