Monetary policy is a term that is used for the actions that are taken by the central banks for determining the supply and availability of money in the economy. Monetary policy also deals with the cost of borrowing or the interest rates. Normally, central bank of the country formulates the monetary policy for ensuring overall development of economy. For example, in United States, Federal Reserve has been entrusted to formulate monetary policies as per the requirement of economy. For affecting the supply of money in economy, two types of monetary policies are used. These are expansionary monetary policy and contractionary monetary policy.
Expansionary monetary policy aims at increasing the supply of money in the economy so that fast development can take place. This type of monetary policy is generally formulated when economy of nation becomes sluggish. For example, whenever a country is hit by recession, central bank formulates expansionary monetary policy so that banks can lend more to businesses for increasing the pace of development. In the year 2008, when the global recession hit many countries, expansionary monetary policy was widely used for stimulating economic growth. The interest rates reached their historic low levels and borrowing become very easy.
There are many types of tools used for increasing lending. As the money supply is increased in economy, more manufacturing activities take place. Services sector also expands and as a result, over a period of time, country comes out of recession or slow development. Economic downturns occur frequently in economy and this is the reason why expansionary policies are formulated very often.
Different types of Tools Used in Monetary Expansionary Policy
Monetary expansionary policy uses different types of tools, all of which aim at improving economic scenario in the country. Three main tools used in monetary policy are change in reserve requirements, change in discount rate and buying and selling of government bonds. Reserve requirements means minimum amount of customer’s deposit that a bank has to hold as reserve and which cannot be used for lending. It is to be understood that all banks make lending out of the deposits they receive from their customers.
Since customers can demand their money any time, banks have to keep certain percentage of deposits as reserve. This percentage changes from time to time as per the requirement of economy. Discount rate is a term used for the interest rate that is charged by the central bank on other banks for lending money for meeting their reserve requirements. By changing discount rate, lending of other banks can be affected greatly. Buying and selling of government bonds is also called as open market operations and these also affect the availability of money in the economy.
In expansionary monetary policy, all these tools are used for putting new money into the system. Idea behind this type of policy is to encourage lending basically. When businesses have access to necessary capital, they are able to increase production and thus, development of economy takes place. In this policy, government increases buying of government bonds from the public.
Money thus received is put into circulation. These bonds are held by different types of investors and are issued as a part of contractionary monetary policy. As a result, money supply in the economy increases. Bonds are generally purchased by paying hard currency or by offering tangible effective capital. Buying of bonds by the government is also called as Quantitative Easing and is considered as one of most effective and useful ways of increasing money in the economy.
In expansionary monetary policy, the central bank also lowers its reserve requirements. Thus, banks are required to keep less percentage of their deposits as reserve. As a result, money available for lending increases automatically. Increased lending by the banks leads to increase in business activities. Over a period of time, economic growth also increases. In the year 2008, Federal Reserve reduced reserve requirements considerably for allowing banks to go for rampant lending.
Similarly, discount rate is also reduced by the central bank for promoting growth and for increasing availability of money in economy. As discount rate is lowered, borrowing becomes less expensive for banks. Banks increase lending considerably, as they can meet reserve requirements by borrowing from the central bank at low rate. Overall supply of money in the economy also increases. In the expansionary policy, discount rate is lower than the interest rates charged by banks for lending money to each other. In other words, by reducing the discount rate, government allow financial institutions to get access to cheap money.
It is to be understood that the rate at which banks borrow money from each other is also set by the central bank. For ensuring fast economic growth, central bank reduces this rate by means of open market operations and thus, supply of money in the economy increases. Sometimes, for avoiding panics in the economy, government extends discount rate window to banks and other financial institutions. For example, in United States, after the attack of 11th September, central bank extended discount window option to banks for preventing insufficient liquidity.
Though expansionary monetary policy is good for increasing economic development of a nation, it is always said that this option must be exercised with caution. This is because excessive supply of money in the economy is also not good. It is one of major reasons for increase in inflation. If that happens, for taming inflation, central bank has to use contractionary monetary policy in which sale of bonds by the government is increased. Reserve requirements and discount rates are also increased.
Expansionary monetary policy should be used for stabilizing the slumping economy so that long-term inflation is not resulted. Since maintaining low inflation is one of key responsibilities of central bank as well as government, expansionary phase is not allowed to run for long time. Generally, this policy is used for a period up to one year, as it takes six months to one year for the effects of increased money supply to become noticeable. Generally, tax cuts and government spending are also increased along with expansionary monetary policy for putting the economy on fast track.