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Monetary Policy

Expansionary Monetary Policy

Expansionary monetary policy is used in a recession to stimulate economic growth and reduce unemployment.

During a recessionary gap, the economy is in short-run equilibrium with output less than the full employment level. This situation results in a high level of unemployment. In this case, the goal of any policy intervention is to increase aggregate demand until the equilibrium output (real GDP) reaches full employment levels (often described as full employment GDP or potential GDP). In the event of a recessionary gap, an intervention in the economy called an expansionary monetary policy may be implemented through central bank actions with the goal of increasing economic growth. These actions can be used to increase aggregate demand and bring the economy back to full employment equilibrium by stimulating investment via interest rates.

The Fed may initiate an expansionary monetary policy when economic growth is slowing or a recession has already begun. This policy can take several forms, but the Fed's preferred mode of operation is purchasing Treasury bills (which have a maturity period of less than a year) in an open-market operation. The Fed also purchases Treasury notes, which are government debt securities with a maturity from 1 to 10 years, and Treasury bonds, which have a maturity greater than 10 years. These purchases are made from the banks that make up the Federal Reserve's membership. As it pays for these securities, the Fed is introducing money into the economy, increasing the funds available for the recipient banks to lend to their customers. The increase in money for lending also decreases interest rates and eases the cost of lending throughout the banking system. Both effects stimulate investment by businesses.

Expansionary Monetary Policy Graph

Expansionary monetary policy is intervention by the Fed with the goal of increasing economic growth. It is called for when a recessionary gap exists between short-run equilibrium output (Y1) and full-employment output (Y2). The Fed acts to move aggregate demand from AD1 to AD2, where the aggregate demand curve meets the intersection of long-run aggregate supply (LRAS) and short-run aggregate supply (SRAS), which represents the point of full-employment output. This also results in an increase in price levels from P1 to P2.
Through these open-market methods, the Fed endeavors to lower the federal funds rate that banks charge each other for the overnight deposits they must leave with the Federal Reserve at the close of each business day. Banks with large reserves lend to banks that need extra funds to cover their overnight deposits. Banks charge one another the federal funds rate to make these loans.

Expansionary Monetary Policy

Expansionary monetary policy is a set of steps taken by the Federal Reserve in response to a recessionary gap. The Fed's policies ripple through the economy, promoting investment and spurring growth. These are the opposite effects of those seen in contractionary policy.
Another tool available to the Fed to help assure economic stability is the discount rate, the interest rate on loans the Federal Reserve makes directly to banks to meet temporary shortages of reserves. Any bank that needs funds to meets its minimum reserve requirements (the minimum amount of cash a commercial bank must maintain) can borrow from the Federal Reserve in exchange for suitable collateral such as Treasury bills, mortgages, and other financial instruments held by the loanee bank. Banks are often reluctant to make use of these short-term loans because they imply that the loanee bank has financial difficulties. Nevertheless, a reduction in the rate of interest charged by the Federal Reserve to banks seeking these short-term loans is another instrument of expansionary policy.

An additional tool the Fed can use in its expansionary monetary policy is to mandate a decrease in reserve requirements. A decrease means a commercial bank does not need to hold as much money in reserve and therefore has more money available to loan to its customers. The increase in outstanding loans provides greater income and greater stability to the banks.

Recently, the Fed has developed new methods of pursuing expansionary monetary policy. One of the most important developments is the policy of quantitative easing, in which a central bank uses money it creates electronically to purchase long-term securities in order to introduce more money into the economy. Whereas an open-market policy attempts to decrease the interest rate, quantitative easing is primarily used when the interest rate is already close to zero. The goal of quantitative easing is to increase the number of loans, not decrease the interest rate. Quantitative easing added a mortgage-backed security (a financial asset backed by mortgages that can be traded) to the list of instruments the Fed can purchase.