Expansionary Monetary Policy

How Low Interest Rates Create More Money for You

••• Expansionary monetary policy is like adding cash to the economy. Photo: Deborah Harrison/Getty Images

Expansionary monetary policy is when a central bank uses its tools to stimulate the economy. That increases the money supply, lowers interest rates, and increases aggregate demand. It boosts growth as measured by gross domestic product.  It usually lowers the value of the currency, thereby decreasing the exchange rate. It is the opposite of contractionary monetary policy.

Expansionary monetary policy deters the contractionary phase of the business cycle.

  But it is difficult for policymakers to catch this in time. As a result, you typically see expansionary policy used after a recession has started. 

How It Works

Let's use the U.S. central bank, the Federal Reserve, as an example. The Fed's most commonly used tool is open market operations. That's when the it buys Treasury notes from its member banks. Where does it get the funds to do so? The Fed simply creates the credit out of thin air. That's what people mean when they say the Fed is printing money.

By replacing Treasury notes with credit in bank coffers, the Fed gives them more money to lend. Banks reduce lending rates, making loans for auto, school, and homes less expensive. They also reduce credit card interest rates. All of this extra credit boosts consumer spending.

When business loans are more affordable, companies can expand to keep up with consumer demand. They hire more workers, whose incomes rise, allowing them to shop even more.

 That's usually enough to stimulate demand, and drive economic growth to a healthy 2-3 percent rate

The Federal Open Market Committe may also lower the fed funds rate. It's the rate banks charge each other for overnight deposits. The Fed requires banks to keep a certain amount of their deposits in reserve at their local Federal Reserve branch office every night.

Those banks that have more than they need will lend the excess to banks who don't have enough, charging the fed funds rate. When the Fed drops the target rate, it becomes cheaper for banks to maintain their reserves, giving them more money to lend. As a result, banks can lower the interest rates they charge their customers.

The Fed's third tool is the discount rate. It's the interest rate the Fed charges banks who borrow from its discount window. However, banks rarely use the discount window because there is a stigma attached. The Fed is considered to be a lender of last resort. Banks only use the discount window when they can't get loans from any other banks. Banks hold this viewpoint, even though the discount rate is usually lower than the fed funds rate. The Fed lowers the discount rate when it decreases the fed funds rate.

The Fed hardly ever uses its fouth tool, lowering the reserve requirement. Even though this immediately increase liquidity, it also requires a lot of new policies and procedures for member banks. It's much easier to lower the fed funds rate, and it's just as effective. During the financial crisis, the Fed created many more monetary policy tools.

Expansionary versus Contractionary Monetary Policy

If the Fed puts too much liquidity into the banking system, it risks triggering inflation.

That's when prices rise more than the Fed's 2 percent inflation target. The Fed sets this target to stimulate healthy demand. When consumers expect prices to increase gradually, they are more likely to buy more now.

The trouble starts when inflation gets higher than 2-3 percent. Consumers start stocking up to avoid higher prices later. That drives demand faster, which triggers businesses to produce more, and hire more workers. The additional income allows people to spend more, stimulating more demand.

Sometimes businesses start raising prices because they know they can't produce enough. Other times, they raise prices because their costs are rising. If it spirals out of control, it can create hyperinflation. That's when prices rise 50 percent or more a month. For more, see Types of Inflation.

To stop inflation, the Fed puts on the brakes by implementing contractionary or restrictive monetary policy. The Fed raises interest rates and sells its holdings of Treasuries and other bonds. That reduces the money supply, restricts liquidity and cools economic growth. The Fed's goal is to keep inflation near its 2 percent target while keeping unemployment low as well. 

Innovative Tools That Conquered the Great Recession

Under the leadership of Federal Reserve Chairman Ben Bernanke, the Fed created an alphabet soup of innovative expansionary monetary policy tools to combat the 2008 financial crisis. They were all ways to pump more credit into the financial system. The Term Auction Facility allowed banks to sell their subprime mortgage-backed securities to the Fed. In conjunction with the Treasury Department, the Fed offered the Term Asset-Backed Securities Loan Facility. It did the same thing for financial institutions holding subprime credit card debt.

In response to a destructive run on money market funds on September 19, 2008, the Fed established the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility. This program loaned $122.8 billion to banks then lend to money market funds. In October, the Fed created the Money Market Investor Funding Facility, which lent directly to the money markets themselves.

The good news is that the Fed reacted quickly and creatively to stave off financial collapse. The credit markets had frozen up, and without this decisive response, the day-to-day cash that businesses use to keep running would have gone dry. The bad news is that the public did not understand what the programs did, so became suspicious of the Fed's motives and power. That led to a drive to have the Fed audited, which was partially fulfilled by the Dodd-Frank Wall Street Reform Act

The Fed also created a more powerful form of open market operations known as quantitative easing, where it added mortgage-backed securities to its purchases.  In 2011, the Fed created Operation Twist. When its short-term notes came due, it sold them and used the proceeds to buy long-term Treasury notes. That lowered long-term interest rates, making mortgages more affordable.