Expansionary Monetary Policy

by Stephan Smith on December 5, 2010

Tilt your head up, clear your throat and say, expansionary monetary policy. What a phrase. If you go around saying this phase to your friends and family, I’m sure you’ll get people talking about how intelligent you are. You’ll be known as an economic expert. But before you start going to friends and family and showing off your intellect, you have to know what it means. Do you know what it means?

Central banks in all countries implement it from time to time and it definitely has an affect on you, so you should know what it means. If you’re unsure as to what this type of monetary policy is, continue to read this page because I will explain just what it is, how it affects an economy and how it is implemented. Soon you’ll be going around telling everyone about expansionary monetary policy and I’m sure that people will be very impressed. Let’s get to it.

Expansionary Monetary Policy Explained

Expansionary monetary policy is a type of monetary policy implemented by central banks that increases the money supply of an economy and thus makes money and credit more accessible to individuals and businesses in an effort to encourage more spending, more hiring and more output of goods and services.

Also known as easing monetary policy, expansionary monetary policy looks to promote economic growth by making money more available primarily through loans. Want to buy a new home? It wouldn’t be too hard to get a mortgage from a commercial bank if the central bank in charge of the economy you’re in is implementing expansionary monetary policies. Want to start a business and need some start up capital? It will be easier to get that loan from a commercial bank if the central bank is implementing expansionary monetary policies. Do you see the trend? The result of expansionary monetary policy is that money and credit become more accessible. In that type of environment, credit card companies, commercial banks, government programs, everyone, is looking to loan to anyone needing money. And they’re not just loaning money, they’re loaning it at great rates. Essentially, getting money becomes more affordable.

Now how does that affect an economy? With money more available to everyone, naturally everyone from businesses to individuals spend more money. Individuals get a mortgage and buy that house they always wanted. Businesses are able to get that loan to invest into better capital goods and hire more people. Now that those people are hired, they have money and they spend more money. They can now afford various durable and non-durable goods. Plus, now that they have a job, they can apply for a loan for a new car or home. And the cycle continues and continues. Do you see what’s happening? Since money is becoming more available due to the implementation of expansionary monetary polices, consumers and producers are a getting more money through loans (which is how the money supply is expanded – known as money expansion) and spending more money, which will result in economic growth.

One thing that I don’t want to forget to mention to you is inflation. You see, if a central bank implements expansionary monetary policies for too long and commercial banks continue to expand the money supply through loans, there will be a time when too much money in available. Yes, I know what you’re thinking. You’re saying, ‘Too much money? Really?’. That’s right. If commercial banks keep expanding the money and engorging the money supply of an economy, then inflationary pressures will start to build. That’s when a central bank would start to consider contractionary monetary policy actions. If a central bank takes too long to implement contractionary monetary policies, inflation will take hold and possibly hyperinflation (really really bad).

How Expansionary Monetary Policy is Implemented

Now that you know what expansionary monetary policy is and how it affects an economy, I want to go over how expansionary monetary policy is implemented. It is primarily implemented by a central bank buying securities. The most common security purchased by central banks are government securities (or government bonds); but central banks buy other types of securities also. Remember, the goal is to make money more available. So to do that a central bank must reinvest earnings from its investments and or create new money and use it to buy securities. Let me explain in detail.

A central bank already has a lot of money invested in its country and it did it primarily by buying government bonds. After a period of time has passed, a central bank would receive payments from its investments (the securities that are purchased by central banks are investment vehicles). Once a central bank has the profit it has earned, it can take two actions. One is to keep the money, which would essentially remove the money from the economy’s money supply (contractionary monetary policy) or it could reinvest the money. When I say reinvest, I mean take the profit and buy more securities. By a central bank purchasing more securities, investors who sold their securities ultimately receive the money. That money then goes into their bank accounts. BOOM, that money is back into circulation and now part of the economy’s money supply. I hope you understand. By a central bank reinvesting its earning, money is going right back into circulation which is an expansionary monetary policy.

If a central bank already is reinvesting all of its earnings and wants to ease monetary policy further, then it can create money. Once money is created, the central bank uses that money to buy securities and further add money into an economy’s money supply. By buying securities, a central bank adds more money into an economy’s money supply and thus makes money and credit more accessible. Buying securities is what expansionary monetary policy is all about. But a central bank must be careful because if it creates too much money and uses it to by securities, then inflation will become severe.

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