Expansionary Monetary Policy
What is Expansionary Monetary Policy?
Expansionary monetary policy increases the money supply to lower interest rates and stimulate aggregate demand.
The central bank buys bonds, lowers the discount rate, or cuts the reserve requirement. Lower interest rates boost investment and interest-sensitive consumption, shifting aggregate demand right. It is used to fight recession and unemployment.
Expansionary Monetary Policy: a worked example
A recession leaves real GDP below potential, so the central bank cuts the required reserve ratio from 20 percent to 10 percent. The banking system holds $80 billion of reserves. Under the old ratio those reserves supported deposits of $80 ÷ 0.20 = $400 billion. Under the new ratio they support $80 ÷ 0.10 = $800 billion, so the money supply can double, an increase of up to $400 billion. On the money market graph the money supply curve shifts right and the nominal interest rate falls from 6 percent to 4 percent. Investment here responds at $35 billion per percentage point, so the 2 point cut adds 2 × $35 billion = $70 billion of investment. With an MPC of 0.8 the spending multiplier is 1 ÷ (1 − 0.8) = 5, and aggregate demand rises by 5 × $70 billion = $350 billion.
The mistake students make with expansionary monetary policy
Jumping straight from more money to more aggregate demand costs points. Students write that the central bank bought bonds so aggregate demand shifted right, skipping the links a rubric actually awards. Spell out the chain. A bond purchase raises reserves, the money supply curve shifts right, the nominal interest rate falls, cheaper borrowing raises investment and interest sensitive consumption, and only then does aggregate demand shift right. The related error is shifting money demand rather than money supply on the graph, which raises the interest rate and reverses the conclusion.
Expansionary Monetary Policy questions
What are the three tools of expansionary monetary policy?
Buying government bonds on the open market, lowering the discount rate, and lowering the required reserve ratio all expand the money supply. Open market purchases are the workhorse, because they add reserves directly and can be done in any size on any day. The reserve requirement is a blunt tool that is rarely changed, and the discount rate works only if banks choose to borrow.
How does expansionary monetary policy reduce unemployment?
Lower interest rates make borrowing cheaper, so firms finance more equipment and construction and households buy more cars and houses. That extra spending shifts aggregate demand right, and firms meeting stronger sales hire more workers, which cuts cyclical unemployment. The channel only reaches unemployment caused by weak demand. Frictional and structural unemployment come from job search and skill mismatch and do not respond to cheaper credit.
Can expansionary monetary policy cause inflation?
Extra money chasing a quantity of goods that cannot expand as quickly bids prices up, and the risk grows as the economy approaches potential output. In a deep downturn with idle factories, most of the stimulus arrives as real output instead. In the long run output returns to potential and the added money shows up entirely in the price level, which is the neutrality result behind every central bank target for how fast prices may rise.
Formula / Example
This is the live Money Market sandbox. Drag the curves, or open the full version.
Related terms
Common comparisons
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