Expansionary Policy - Explained
What is Expansionary Policy?
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Table of ContentsWhat is Expansionary Policy?Why is Expansionary Policy Important?Expansionary Monetary PolicyExamples of Expansionary PolicyAcademic Research on Expansionary Policy
What is Expansionary Policy?
In macroeconomics, the expansionary policy is a policy that the Federal Reserve uses to increase the supply of money and stimulate economic growth. An expansionary policy can comprise of fiscal policy, monetary policy, or a combination of both. In cases of recessions and economic slowdowns, the Federal Reserve also uses the policy to moderate the bad economic cycles.
Why is Expansionary Policy Important?
According to Keynesian economics, the root cause of economic slowdowns is the shortage of aggregate demand. Therefore, the main purpose of the expansionary policy is to increase the aggregate demand for money. The aggregate demand compensates for any deficits in private demand. The expansionary policy also increases consumer spending and business investments by ensuring there is a supply of money in the economy. The federal reserve accomplishes this either by increasing lending of funds to individuals and businesses or by reducing government expenditure. The government enforces the expansionary fiscal policy by increasing the supply of money in the economy. The expansionary fiscal policy comprises transfer payments, government spending on projects, rebates, and income tax cuts. The government cuts down income tax rates and uses tools to budget, thereby providing more money to consumers, and this increases the rate of spending. Other activities to increase purchasing power include hiring and contracting new employees in the government. The purchasing power of consumers contributes to approximately seventy percent of the general economy. The supply-side economics theory advocates for lower corporate taxes and not lower income taxes to grow the economy. Tax cuts in the corporate sector leave businesses and corporations with more money to invest and hire new employees. In case the company has enough employees, then it can use the extra money to buy stocks, bonds, or buy new companies. If the government uses the correct strategies, expansionary fiscal policy works almost immediately. The government directing their expenditure towards hiring people reduces the unemployment rate in the country. Income tax cuts mean that the employees have more money to spend, and this grows the economy. Generally, the expansionary fiscal policy brings back the confidence of consumers and corporations. Although tax cuts are advantageous to the public, it causes a decrease in the government's revenue creating a shortage in the budget. Tax cuts should not last long since the economy should recover and pay off debts.
Both fiscal and monetary policies work by increasing the supply of money to business owners, industries, and individuals who then circulate the money in the market. In an expansionary policy, there is a transfer of wealth and purchasing power from old to new users of the money. Operations involving transfers of huge amounts of money to the public are subject to political criticism. Therefore, bankers need to properly analyze the market with the help of analysts to ensure they use the correct strategies in building the countrys economy.
Expansionary Monetary Policy
A central bank enforces the expansionary monetary policy by increasing aggregate demand, lowering interest rates, and increasing the supply of money to boost the economy. The Federal Reserve implements the expansionary monetary policy to boost the economy by using the following strategies;
- Open market operations
The Fed can increase the supply of money in the economy when it buys securities and assets in the open market. For example, purchasing treasury bonds can cause an increase in prices since many people are buying, and in return lowers the profits. When the Fed assigns low-interest rates on treasury bonds, people can move to other investment options, making cash flow in other areas in the market.
- Reducing reserve requirements
Reserve requirements refer to the specific sum of money that banks should have in their reserves. When the Fed sets the limit to a lower amount, banks can have extra money, and use it to invest or lend out to business owners.
- Reducing the discount rate
The Fed charges banks a fee when they borrow money from each other. Banks can also borrow money from the Federal reserve at a discount. When the Fed lowers its discount rate, it also means that the interest rates will be low, and the cost of money will also be less. The strategies of an expansionary monetary policy increase the availability of money. However, the policy has a risk. A lot of free money can cause a decrease in the value of the currency, and may also cause inflation. A low currency value leads to a decrease in the currencys exchange rate. Legislators and central bankers need to know when to stop the excessive supply of money because it can destroy the economy, and it may take a long time to reverse the effects.
Examples of Expansionary Policy
President Obamas administration reduced income tax rates, increased unemployment benefits, and funded a lot of public work projects by using expansionary policy. By 2010, Obama has increased the benefits with more tax cuts, and increased spending of the US defense forces. All this caused an increase in the national debt. From 2014 through 2016, when the prices of oil declined, the economies of many countries slowed down and profits also decreased. The slow economic growth hit Canada hard, almost making its banks to fall. Canada dealt with the low prices of oil by incorporating the expansionary policy to boost its economy. The policy aimed to reduce the interest margins of Canadian banks, allowing the banks to make some profits.
Academic Research on Expansionary Policy