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Expansionary Monetary Policy

Updated: Sep 10, 2019

Theme 7: Macroeconomics Policies

Topic: Expansionary Monetary Policy

Relevance: H1 and H2 Economics

Introduction:

Government can introduce demand management policy of monetary fiscal policy through the central bank to achieve its macroeconomic goals of economic growth and lower unemployment.


Expansionary monetary policy could include increasing the money supply or decreasing the interest rate. A central bank can increase the money supply, would is the amount of money circulating the economy through the use of measures such as purchasing bonds or lending money to financial institutions, decreasing the reserve ratio requirements of commercial banks or decreasing interest rate directly.


When money supply increases, interest rate would decrease. This would lead to a decrease in the cost of borrowing. Firms and entrepreneurs would have more incentive to borrow for investment (I). Households would also be more inclined to borrow and increase consumption expenditure (C), especially on big ticket items such as cars and houses. Decrease in interest rate would also decrease the return of savings therefore reducing household’s willingness to save which will contribute to increase in consumption.


Increase in consumption expenditure (C) and investment expenditure (I) would lead to an increase in aggregate demand and the aggregate demand curve to shift right from ADOriginal to ADNew in Figure 1.

Figure 1: Increase in Aggregate Demand

When aggregate demand increases, there will be excess demand in the short run at original price level P0 as aggregate demand is more than aggregate supply. This will lead to unplanned shortage of inventories and hence induce firms to increase their output level in the next period leading to an increase in the real national income via the multiplier effect from YO to YN and inflation as general price level increases from P0 to PN. As real output increases, firms would employ more resources such as labour, resulting in an increase in demand of labour. Increase in demand of labour will lead to a fall in unemployment,

especially demand-deficient unemployment. Therefore, expansionary fiscal policy would result an increase in real national income, decrease in unemployment but also inflation as general price level increased.



Advantages of using Expansionary Monetary Policy

  • Monetary policy involves financial institutions like banks which are the main financial intermediaries in any economy. These banks subsequently influence consumption and investment decisions which exert large impacts on the economy.

  • Expansionary Monetary Policy does not negatively affect government’s fiscal position as it doesn’t negative affect tax revenue or government spending.

  • Interest rate and money supply are flexible and can be adjusted over time more easily.

  • Expansionary Monetary Policy can be used as a long term or sustainable policy.

  • Expansionary Monetary Policy increase employment and decreases unemployment.

  • Situation for country with a larger multiplier size as real income will increase more compared to another country with a smaller multiplier.

  • The effectiveness of Expansionary monetary policy depends on the interest elasticity of demand for loans. If the demand for loans is interest elastic, expansionary monetary policy will be more effective.

Disadvantages of using Expansionary Monetary Policy

  • Increase in AD would result in an increase in GPL or Inflation which will have adverse impact on the economy.

  • Not situation for country with a smaller multiplier size as real income will increase lesser compared to another country with a larger multiplier.

  • Expansionary Monetary Policy does not suit economies with a fixed exchange rate system.

  • Expansionary Monetary Policy does not suit economies open to capital flows.

  • The effectiveness of Expansionary monetary policy depends on the interest elasticity of demand for loans. If the demand for loans is interest inelastic, expansionary monetary policy will be less effective.

  • Consumption and investment decision depends on many factors other than interest rates such as political stability, market conditions and outlook.

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