Understanding Expansionary Policy

The basic objective of expansionary policy is to boost aggregate

demand to make up for shortfalls in private demand. It is based
on the ideas of Keynesian economics, particularly the idea that
the main cause of recessions is a deficiency in aggregate
demand. Expansionary policy is intended to boost business
investment and consumer spending by injecting money into the
economy either through direct government deficit spending or
increased lending to businesses and consumers.
From a fiscal policy perspective, the government enacts
expansionary policies through budgeting tools that provide
people with more money. Increasing spending and cutting taxes
to produce budget deficits means that the government is putting
more money into the economy than it is taking out.
Expansionary fiscal policy includes tax cuts, transfer payments,
rebates and increased government spending on projects such as
infrastructure improvements.
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.
Expansionary monetary policy works 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. 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.

On August 27, 2020 the Federal Reserve announced that it will

no longer raise interest rates due to unemployment falling below
a certain level if inflation remains low. It also changed its
inflation target to an average, meaning that it will allow inflation
to rise somewhat above its 2% target to make up for periods
when it was below 2%.
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 central bank purchases debt instruments, it injects capital
directly into the economy.
The Risks of Expansionary Monetary Policy
Expansionary policy is a popular tool for managing low-growth
periods in the business cycle, but it also comes with risks. These
risks include macroeconomic, microeconomic, and political
economy issues.
Gauging when to engage in expansionary policy, how much to
do, and when to stop requires sophisticated analysis and
involves substantial uncertainties. Expanding too much can
cause side effects such as high inflation or an overheated
economy. 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.
Even under ideal conditions, expansionary fiscal and monetary
policy risk creating microeconomic distortions through the
economy. Simple economic models often portray the effects of
expansionary policy as neutral to the structure of the economy as
if the money injected into the economy were distributed
uniformly and instantaneously across the economy.
In actual practice, monetary and fiscal policy both operate by
distributing new money to specific individuals, businesses, and
industries who then spend and circulate the new money to the
rest of the economy. Rather than uniformly boosting aggregate
demand, this means that expansionary policy always involves an
effective transfer of purchasing power and wealth from the
earlier recipients to the later recipients of the new money.
In addition, like any government policy, an expansionary policy
is potentially vulnerable to information and incentive problems.
The distribution of the money injected by expansionary policy
into the economy can obviously involve political considerations.
Problems such as rent-seeking and principal-agent problems
easily crop up whenever large sums of public money are up for
grabs. And by definition, expansionary policy, whether fiscal or
monetary, involves the distribution of large sums of public
money.
Examples of Expansionary Policy
A major example of expansionary policy is the response
following the 2008 financial crisis when central banks around
the world lowered interest rates to near-zero and conducted
major stimulus spending programs. In the United States, this
included the American Recovery and Reinvestment Act and
multiple rounds of quantitative easing by the U.S. Federal
Reserve. U.S. policy makers spent and lent trillions of dollars
into the U.S. economy in order to support domestic aggregate
demand and prop up the financial system.
In a more recent example, declining oil prices from 2014
through the second quarter of 2016 caused many economies to
slow down. Canada was hit especially hard in the first half of
2016, with almost one-third of its entire economy based in the
energy sector. This caused bank profits to decline, making
Canadian banks vulnerable to failure.
To combat these low oil prices, Canada enacted an expansionary
monetary policy by reducing interest rates within the country.
The expansionary policy was targeted to boost economic growth
domestically. However, the policy also meant a decrease in net
interest margins for Canadian banks, squeezing bank profits.
Related Terms
Fiscal Policy
Fiscal policy uses government spending and tax policies to
influence macroeconomic conditions, including aggregate
demand, employment, and inflation.
more
Stimulus Package
A stimulus package is a package of economic measures put
together by a government to stimulate a struggling economy.
more
What Is Stabilization Policy?
Stabilization policy is a government strategy intended to
encourage steady economic growth, even price levels, and
optimal employment numbers.
more
Economic Stimulus
Economic stimulus refers to attempts by governments or
government agencies to financially kickstart growth during a
difficult economic period.
more
Monetarism Definition
Monetarism is a macroeconomic theory, which states that
governments can foster economic stability by targeting the
growth rate of money supply.
more
Circular Flow Model
The circular flow model of economics shows how money moves
through an economy in a constant loop from producers to
consumers and back again.
more
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