What is the effect of expansionary monetary policy on equilibrium interest rate?

Interest rates and the amount of loanable money available are influenced by monetary policy, which in turn influences numerous components of aggregate demand. Two components of aggregate demand will be lowered if monetary policy is tight or contractionary, resulting in higher interest rates and a smaller pool of loanable funds. Business investment will fall as it becomes less appealing for businesses to borrow money, and even businesses that already have money will discover that, with rising interest rates, it is more appealing to put those funds in a financial investment rather than a physical capital investment. Furthermore, increased interest rates will deter consumers from borrowing for large-ticket purchases such as houses and cars. Conversely, loose or expansionary monetary policy that hints to lower interest rates and a higher quantity of loanable funds will tend to surge business investment and consumer borrowing for big-ticket items.

If the economy is suffering a recession and high unemployment, with output below potential GDP, expansionary monetary policy can help the economy return to potential GDP. This example uses a short-run upward-sloping Keynesian aggregate supply curve (SRAS). The original equilibrium during a recession of E0 occurs at an output level of 600. An expansionary monetary policy will reduce interest rates and stimulate investment and consumption spending, causing the original aggregate demand curve to shift right to AD1, so that the new equilibrium occurs at the potential GDP level of 700.

A contractionary monetary policy, on the other hand, can lower inflationary pressures for a rising price level if an economy is producing at a quantity of production over its potential GDP. The initial equilibrium is reached at a production level of 750, which is higher than potential GDP. A contractionary monetary policy raises interest rates, discourages borrowing for investment and consumer expenditure, and causes the original demand curve to move left to AD1, resulting in a new equilibrium (E1) at 700.

These instances show that monetary policy should be countercyclical, in the sense that it should act to balance out economic downturns and upswings. When unemployment rises as a result of a recession, monetary policy should be loosened; when inflation threatens, it should be tightened. Of course, there is a risk of overreaction with countercyclical policy. If monetary policy is excessively loose to terminate a recession, aggregate demand may be pushed too far to the right, triggering inflation. If monetary policy tightens too much in an attempt to lower inflation, aggregate demand may shift so far to the left that a recession occurs. The chain of consequences connecting loose and tight monetary policy to changes in output and price level is summarised. A central bank may engage in expansionary monetary policy by purchasing treasury notes, lowering interest rates on bank loans, or lowering the reserve requirement. All of these measures expand the money supply, lowering interest rates. This encourages banks to lend and businesses to take out loans. Through employment, debt-financed corporate expansion can have a favourable impact on consumer spending and investment, hence raising aggregate demand.

Author Info

Citation: Inaebnit E (2021) The Effect of Monetary Policy on Aggregate Demand. Global J Comm Manage Perspect. 10: e001.

Received: 02-Dec-2021 Accepted: 16-Dec-2021 Published: 23-Dec-2021

Copyright: © 2021 Inaebnit E. This is an open-access article distributed under the terms of the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original author and source are credited.

Expansionary, or loose policy is a form of macroeconomic policy that seeks to encourage economic growth. Expansionary policy can consist of either monetary policy or fiscal policy (or a combination of the two). It is part of the general policy prescription of Keynesian economics, to be used during economic slowdowns and recessions in order to moderate the downside of economic cycles.

Key Takeaways

• Expansionary policy seeks to stimulate an economy by boosting demand through monetary and fiscal stimulus.
• Expansionary policy is intended to prevent or moderate economic downturns and recessions.
• Though popular, expansionary policy can involve significant costs and risks including macroeconomic, microeconomic, and political economy issues.

1:43

Expansionary Policy

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.

How does expansionary monetary policy affect interest rates?

What is the effect of expansionary fiscal policy on equilibrium interest rate?

How monetary policy affects the equilibrium interest rate?

Does expansionary monetary policy reduce the equilibrium price level?