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 requirement.
All of these options have the same purpose; to expand the money supply for the country.
Key Takeaways
- A central bank, such as the Federal Reserve in the U.S., will use expansionary monetary policy to strengthen an economy.
- The three key actions by the Fed to expand the economy include a decreased discount rate, buying government securities, and a lowered reserve ratio.
- Quantitative easing is another monetary policy tool used by central banks.
- The Fed implemented an expansionary policy during the 2000s following the Great Recession, lowering interest rates and utilizing quantitative easing.
- An expansionary monetary policy goes hand in hand with an expansionary fiscal policy, the latter of which is managed by the government.
Stimulating Expansionary 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 is meant to result in lower interest rates and borrowing costs, with the goal to boost consumption and investment.
Interest Rates
When interest rates are already high, the central bank focuses on lowering the discount rate. The discount rate is the interest rate that banks can borrow money from the Federal Reserve. There is a multitude of reasons why a bank may borrow from the Fed.
These include meeting reserve requirements, cash needed for operations, or general liquidity. Banks, however, borrow from the Fed as a last resort, preferring to borrow from other banks as the rates are lower.
The lower the discount rate, the fewer financing costs for a bank, therefore, money is cheaper. When the discount rate is lowered, banks will lower the interest rate they charge customers for borrowing money as well.
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 to spend their money and invest in riskier assets.
Open Market Operations
Open market operations refer to the Fed's practice of purchasing Treasuries on the open market. This increases the demand for the securities, increases their price/decreases their yield, and injects money into the economy.
Purchasing Treasuries from banks increases their reserves, which makes it easier for them to lend out money to customers, making it easier for people to buy homes, cars, etc, and businesses to start or expand.
Quantitative Easing
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, usually Treasuries and agency mortgage-backed securities (MBSs). This is known as quantitative easing (QE).
QE stimulates the economy by introducing capital into the economy and lowering the interest rate as there is increased demand for fixed-income securities. It provides overall liquidity to banks as the central bank purchases assets, which increases the reserve requirements of banks, which can then use that increased liquidity to make riskier investments, such as making loans to individuals and businesses, which further stimulates the economy.
Quantitative easing is often used interchangeably with credit easing, though QE technically refers to increasing bank reserves whereas credit easing refers to increasing the balance sheet through the purchase of securities.
The primary difference between open market operations and quantitative easing is that open market operations is a primary tool whereas quantitative easing is an alternative tool. Also, open market operations is typically a continuous process whereas QE is only used in times of economic difficulty.
Reserve Requirement
Reserve requirements are the amount of reserves that banks are required to keep on hand as stipulated by a central bank. The reserve requirement directly relates to the amount of deposits that customers have at the institution.
Banks use customer deposits to make loans to other customers. The number of loans they can make is limited by the amount of reserves they are required to keep on hand. The more reserves they are required to keep, the less money they can lend out. The fewer reserves they are required to keep, the more money they can lend out.
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. With more reserves on hand, banks are more likely to lend out money, thereby stimulating the economy.
Real-World Examples
The Great Recession
A recentexample of expansionary monetary policy was seen in the U.S. in the late 2000s during theGreat 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 quantitative easing, purchasing government securities from January 2009 until August 2014, for a total of $3.7 trillion.
COVID-19 Pandemic
In 2020, when the Coronvirus swept the world and most countries went into lockdown, economies were hit hard by the lack of economic activity. To bolster the economy, the Fed implemented a quantitative easing program.
The size of the Fed's balance sheet as of February 2022 is approximately $8.9 trillion compared to $918 billion in 2008 right before the financial crisis.
On March 15, 2020, the Fed announced that it would purchase $500 billion in Treasury securities and $200 billion in agency MBSs to stimulate the economy.
What Is Expansionary Monetary Policy?
Expansionary monetary policy is a set of tools used by a nation's central bank to stimulate the economy. To do this, central banks reduce the discount rate—the rate at which banks can borrow from the central bank—increase open market operations through the purchase of government securities from banks and other institutions, and reduce the reserve requirement—the amount of money a bank is required to keep in reserves in relation to its customer deposits. These expansionary policy movements help the banking sector perform well.
What Are the Goals When a Government Uses Expansionary Monetary Policy?
The goal of expansionary monetary policy is to grow the economy, particularly in times of economic trouble. The overall aim is to increase consumer and business spending by increasing the money supply through a variety of measures that improve liquidity. The intended purpose is an increase in the money supply, a decrease in interest rates, and an increase in demand.
What Is the Difference Between Monetary Policy and Fiscal Policy?
Monetary policy is enacted by a country's central bank and seeks to influence the money supply in a nation. Fiscal policy is enacted by a country's government through spending and taxes to influence a nation's economic conditions.
The Bottom Line
Expansionary monetary policies are enacted by a country's central bank to help spur the economy. The goal is to increase the money supply, bring stability, and increase liquidity. The primary tools that central banks use to expand monetary policy include lowering the discount rate, increasing the purchase of government securities, and reducing the reserve requirement.
