Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Expansionary Policy

What it is:

Expansionary policy, or expansionary monetary policy, is when the Federal Reserve uses tools at its disposal in order to increase the money supply for the purpose of stimulating or growing the economy.

How it works (Example):

An expansionary policy is typically implemented by the Federal Reserve by enacting one or more of these tactics:

Lowering the federal discount rate
By lowering the discount rate, the fees it charges banks to borrow from it, the Fed seeks to lower overall interest rates, thereby lowering the cost of money and its availability.

Lowering reserve requirements
Reserve requirements are the amount of money banks must keep in reserve.  Lowering these reserves enables banks to have more money available to lend and invest.

Open market operations
By purchasing securities on the open market, the Fed injects more money into the economy.  Buying treasuries, for example, theoretically has the effect of increasing the price (caused by more buying) and thus lowering the yields.  Lower interest rates on treasuries can make other investment more attractive, and cause money to flow into other sources.

[Learn more about open market operations here.]

Why it Matters:

These tactics primarily make money more available by lowering interest rates.  By making it cheaper to borrow money, the Fed seeks to increase investment which in turn can increase hiring and consumption and lift the overall growth of the economy.  This policy does carry risk however. 

Too much easy money can lead to inflation if more dollars in the economy chase fewer goods on a relative basis.  The Fed can counter inflation by using contractionary monetary policy which uses the same tactics in reverse (raising the discount rate,  raising reserve requirements, and selling securities on the open market) in order to decrease the money supply and counter inflation.

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