Select your language

Suggested languages for you:
Log In Start studying!
StudySmarter - The all-in-one study app.
4.8 • +11k Ratings
More than 3 Million Downloads
Free
|
|

All-in-one learning app

  • Flashcards
  • NotesNotes
  • ExplanationsExplanations
  • Study Planner
  • Textbook solutions
Start studying

Expansionary and Contractionary Monetary Policy

Save Save
Print Print
Edit Edit
Sign up to use all features for free. Sign up now
Expansionary and Contractionary Monetary Policy

What monetary policy should The Federal Reserve pursue when the inflation rate reaches 8.5%? How did monetary policy help lower the impact of COVID-19 on the economy? How do countries choose to pursue their monetary policies?

Let's have a look at expansionary and contractionary money policy and answer these questions and more.

Expansionary and Contractionary Monetary Policy Definition

In times of severe economic crisis, such as hyperinflation or a fall in real GDP, the economy might get out of control, and institutions that help bring the economy back on track are needed. Countries establish central banks to ensure a stable and sound economy to protect against periods of economic crisis and tackle crises using the right policy tools.

The central bank of the United States is the Federal Reserve System, commonly referred to as "the Fed". It is an independent body the ultimate goal of which is to act in the best interest of the country's economy rather than design policies to help governments win another election.

The Fed uses monetary policy tools to address different economic developments. The Fed doesn't always implement policies, only during periods with lower economic output. The Fed also uses monetary policy in periods where there is growth, of course, to ensure that the growth keeps a healthy track.

An expansionary policy can be used to stimulate growth to meet full employment output if the economy is in a negative output gap, the same with positive output gaps and recessionary policies. An output gap is when an economy is inefficiently using its resources, either with too much inflation or too much unemployment.

Two main types of monetary policies pursued by the Fed include expansionary monetary policy and contractionary monetary policy.

Expansionary monetary policies are monetary policies that increase the aggregate demand in the economy.

Contractionary monetary policies are monetary policies that decrease the aggregate demand curve in the economy.

Note that both policies aim to target the aggregate demand curve. By controlling the aggregate demand curve, the Fed can ensure that the output in the economy is at healthy levels as well as the price levels.

Both expansionary and contractionary monetary policies impact the aggregate demand, the price level, the real GDP, and the interest rate. Both types of policies increase or decrease the supply of money in an economy, which alters all transactions.

The AD-AS model analyzes the short-run impact of an expansionary or contractionary monetary policy. This model makes it easier to track changes in price and output more clearly.

Expansionary and Contractionary Monetary Policy Differences

Both expansionary and contractionary monetary policies are policies the Fed uses to address economic shocks. The main difference between them is that expansionary monetary policy increases Aggregate Demand, whereas contractionary monetary policy decreases Aggregate Demand.

Expansionary and Contractionary Monetary Policy Graph

Before we move on to the expansionary and contractionary monetary policy graphs, you need to understand a couple of things. Whether the Fed chooses to pursue an expansionary or a contractionary monetary policy, there are three main tools it uses: the reserve requirements ratio, open-market operations, and the discount rate.

Reserve Requirement Ratio

The reserve requirement ratio is the portion of funds banks must maintain in their reserves and can’t use to generate loans. This required reserve is to protect banks from loading too much of their funds, which can risk a collapse. When the Fed wants to pursue an expansionary monetary policy, it reduces the reserve requirement ratio.

This reduction then lowers the amount of funds banks are required to maintain in their reserves and can generate more loans. This drops the interest rate in the economy, and individuals have more money in their hands, resulting in an overall increase in the Aggregate demand curve. Fed increases the reserve requirement ratio when it wants to pursue a contractionary monetary policy.

Open market operations

This is another tool the Fed uses to pursue a contractionary or expansionary monetary policy. Open market operations refers to the buying or selling of securities from the market by the Fed. When the Fed wants to pursue a contractionary monetary policy, meaning that it wants to reduce the aggregate demand in the economy, it does so by selling securities in the market.

These securities are safe investments at a standard market rate. This reduces the amount of money people hold in their hands as they buy the securities sold by the Fed. As there is less money in the economy, the aggregate demand falls.

Discount rate

The discount rate is the rate at which commercial banks borrow from the Fed. When the Fed wants to pursue an expansionary monetary policy, they lower the discount rate, making it less expensive for commercial banks to borrow from the Federal Reserve. As a result, they can generate more loans, and as such more money flows into the market. This boosts consumption, which in turn increases the aggregate demand curve.

expansionary and contractionary monetary policy graph studysmarterFigure 1. Expansionary policy graph. StudySmarter Originals

Figure 1 shows the expansionary monetary policy graph. Whenever there is a shift of the aggregate demand curve to the right, increasing overall production and the price level, the Fed is said to be pursuing an expansionary monetary policy. Keep in mind that the Fed influences the aggregate demand curve by one of the previously mentioned tools.

expansionary and contractionary monetary policy graph studysmarterFigure 2. Contractionary Monetary Policy StudySmarter Originals

Figure 2 shows the contractionary monetary policy graph. Whenever the Fed decides to pursue a contractionary monetary policy, the price level is aimed to decrease alongside the overall output in the economy, hence the term "contractionary". Again, the Fed uses one of its monetary policy tools to shift the aggregate demand curve to the left. This policy is usually pursued in times of inflation when the government wants to reduce the aggregate demand to lower the price level.

Whether the Fed decides to pursue an expansionary monetary policy or a contractionary one, it will always be faced with the time lag of the policy, which is the time it takes for the monetary policy to have an effect on the economy. That’s because of both the time it takes to recognize that there is a problem in the economy and the time it takes for the economy to absorb the monetary policy change.

Expansionary and Contractionary Monetary Policy Examples

There are many examples of expansionary and contractionary monetary policies. Usually, you can find expansionary policies implemented when the economy is in recession, and the total output has fallen. Contractionary policies are implemented when there is inflation and growth in the economy.

An example of an expansionary monetary policy is how the Fed addressed the Covid 19 crisis. When Covid hit the economy and the U.S government decided to implement lockdowns and measures to address the health crisis, an economic crisis also emerged. Many businesses were shut down, and aggregate demand fell significantly. That was the drop in consumer spending as many individuals had to stay at home.

Additionally, investment spending fell as investors were uncertain about how the pandemic will develop and its impact on economies. The overall U.S economy was characterized by a drop in aggregate demand, which caused the overall output to fall. The economy desperately needed stimulation. The Fed needed to increase the aggregate demand to increase the overall production in the economy.

Using one of its monetary policy tools, the Fed increased the money supply in the economy, which lowered the interest rates; as too much money fled the market, there was no need to pay a higher price to borrow. This action caused investment spending to increase in the economy, and many businesses were reopened as they could borrow money to cover the losses covid caused.

The increase in investment spending and businesses receiving funds also increased the income for individuals. This income increase caused consumer spending to grow, and as a result, the aggregate demand shifted to the right, resulting in higher overall output in the U.S economy.

At the time of writing this article, two years after the pandemic, the increase in money supply, which shifted to the aggregate demand curve to the right, caused the U.S inflation to increase at high levels, 8.5%. This increase caused many institutions to worry, and the Fed is significantly considering bringing down inflation.

The Fed has already started increasing the interest rate in the economy, which will reduce the money supply. A higher interest rate would mean less investment spending and less consumer spending, which would cause the aggregate demand curve to shift to the left. This would cause the overall production to fall, together with the price level.

Expansionary and Contractionary Monetary Policy Advantages

Expansionary and contractionary monetary policy advantages include the ability of the Fed to solve a decline in output or a rise in the price level. Based on the present state of the economy, the Fed uses monetary policy instruments to boost consumer spending and ensure stable economic growth. Whenever a stimulus is required to keep the economy growing, the Fed can implement an expansionary policy which is characterized by a lower interest rate.

Lower interest rates then ensure that businesses and individuals can be more confident in spending and investing. Investment and spending increases the available cash to move around the economy, which helps increase growth faster than if no policy changes occur.Contractionary and expansionary monetary policy contribute to the stability of the global economy. The majority of countries function based on currencies exchanged in value against one another. There is no gold standard today among the most powerful financial countries globally.

As a result, a government that chooses to create more money would see its currency depreciate, which would lead to an increase in exports. On the other hand, if it wanted to focus more on imports, it would pursue a contractionary policy, which would increase its currency's value. All of this is made possible by expansionary and monetary policies.

Expansionary and Contractionary Monetary Policy - Key takeaways

  • Expansionary policies are used to tackle a fall in the overall production in the economy (read: GDP).
  • Contractionary policies are used during inflationary periods, where there is output growth, but are associated with a price increase.
  • Expansionary and contractionary policies can be enacted to bring an economy back to full employment output. The policy type implemented depends on whether the output gap is positive or negative.
  • Both expansionary and contractionary monetary policies impact the aggregate demand, the price level, the real GDP, and the interest rate.
  • The AD-AS model explains the impact of expansionary and monetary policies on the economy.
  • There are time lags in monetary policy because of both the time it takes to recognize that there is a problem in the economy and the time it takes for the economy to absorb the monetary policy change.

Frequently Asked Questions about Expansionary and Contractionary Monetary Policy

Expansionary monetary policies increase the aggregate demand in the economy.

Contractionary monetary policies  decrease the aggregate demand curve in the economy.

An example of expansionary policies is the decrease in interest rates in response to the Covid 19 crisis. In periods of high growth, the Fed will increase interest rates to curtail inflation.

Expansionary monetary policies cause the aggregate demand to increase. 

Contractionary monetary policies cause the aggregate demand to fall.

Both expansionary and contractionary monetary policy are policies the Fed use to address economic shocks. The main difference between them is that expansionary monetary policy increases aggregate demand, whereas contractionary monetary policy decreases Aggregate Demand.

The Fed pursues both expansionary and contractionary monetary policies based on the economic situation and needs.

Final Expansionary and Contractionary Monetary Policy Quiz

Question

What is Expansionary Monetary Policy?

Show answer

Answer

Expansionary monetary policies are monetary policies that increase the aggregate demand in the economy.

Show question

Question

What Contractionary Monetary Policy?

Show answer

Answer

Contractionary monetary policies are monetary policies that decrease the aggregate demand curve in the economy.

Show question

Question

What are examples of Expansionary Monetary Policy?


Show answer

Answer

An example of expansionary policies is the decrease in interest rates in response to the Covid 19 crisis.

Show question

Question

What are examples of Contractionary Monetary Policy?

Show answer

Answer

Increasing interest rate to control the increase in inflation.

Show question

Question

What are the effects of Expansionary and Contractionary Monetary Policy?


Show answer

Answer

Expansionary monetary policy cause the aggregate demand to increase. 

Contractionary monetary policies cause the aggregate demand to fall.

Show question

Question

What is the difference between expansionary and contractionary policy?


Show answer

Answer

Both expansionary and contractionary monetary policy are policies Fed use to address economic shocks. The main difference between them is that expansionary monetary policy increases aggregate demand, whereas contractionary monetary policy decreases Aggregate Demand.

Show question

Question

Does the Federal Reserve pursue an expansionary or a contractionary monetary policy?


Show answer

Answer

The Fed pursues both expansionary and contractionary monetary policies based on the economic situation and needs.

Show question

Question

What monetary policy is used when there is a fall in real GDP?

Show answer

Answer

Expansionary monetary policy.

Show question

Question

What monetary policy is used when there is an increase in the real GDP?


Show answer

Answer

Contractionary monetary policy.

Show question

Question

What are some of the economic variables impacted by expansionary and contractionary monetary policies?

Show answer

Answer

Both expansionary and contractionary monetary policies impact the aggregate demand, the price level, the real GDP, and the interest rate.

Show question

Question

What is the relationship between AD-AS model and expansionary and contractionary monetary policies?

Show answer

Answer

The AD-AS model explains the impact of expansionary and monetary policies on the economy.

Show question

Question

What are lags to monetary policy?

Show answer

Answer

Whether the Fed decides to pursue an expansionary monetary policy or a contractionary one, it will always be faced with the time lag of the policy, which is the time it takes for the monetary policy to have an effect on the economy.

Show question

Question

Why there are lags to monetary policy?

Show answer

Answer

There are time lags in monetary policy because of both the time it takes to recognize that there is a problem in the economy and the time it takes for the economy to absorb the monetary policy change.

Show question

Question

What are the three main tools the Fed uses to conduct expansionary or contractionary monetary policy?

Show answer

Answer

Whether the Fed chooses to pursue an expansionary or a contractionary monetary policy, there are three main tools it uses: the reserve requirements ratio, open-market operations, and the discount rate.

Show question

Question

What kind of monetary policy would the Fed be pursuing if it decreased the reserve requirement ratio?

Show answer

Answer

When the Fed wants to pursue an expansionary monetary policy, it reduces the reserve requirement ratio. This then lowers the amount of funds banks are required to maintain in their reserves and can generate more loans. This drops the interest rate in the economy, and individuals have more money in their hands. This results in an overall increase in the Aggregate demand curve.

Show question

Question

______ _______ ______ is used by the Fed to stimulate growth and close a negative output gap.

Show answer

Answer

Expansionary monetary policy

Show question

Question

______ _______ ______ is used by the Fed to restrict growth and close a positive output gap.

Show answer

Answer

Contractionary monetary policy

Show question

Question

A _______ output gap occurs when there is inflation.

Show answer

Answer

Positive

Show question

Question

A ________ output gap occurs when there is a recession.

Show answer

Answer

Negative

Show question

Question

Expansionary and contractionary monetary policy aim to affect _______

Show answer

Answer

Aggregate demand

Show question

Question

_______ monetary policy increases aggregate demand; _______ monetary policy decreases aggregate demand.

Show answer

Answer

Expansionary; contractionary

Show question

Question

Expansionary monetary policy ______ price level and _______ output

Show answer

Answer

Increases; increases

Show question

Question

Contractionary fiscal policy ______ price level and ______ output.

Show answer

Answer

Decreases; decreases

Show question

Question

This tool consists of buying and selling financial assets.

Show answer

Answer

Open-market operations

Show question

Question

This tool consists of altering the amount of money banks must hold on to.

Show answer

Answer

Reserve requirement

Show question

Question

This tool consists of altering the interest rate that banks pay to take loans from the Fed.

Show answer

Answer

Discount rate

Show question

Question

True or False: Buying government securities will increase the money supply.

Show answer

Answer

True

Show question

Question

True or False: Raising the discount rate will lower the money supply.

Show answer

Answer

True

Show question

Question

True or False: There is an inverse relationship between the reserve requirement and money supply.

Show answer

Answer

True

Show question

Question

Expansionary monetary policy is useful when:

Show answer

Answer

The economy is in a recession

Show question

Question

Contractionary monetary policy is most useful when:

Show answer

Answer

There is inflation

Show question

Question

True or False: Tax rates are a tool used by the Fed

Show answer

Answer

False

Show question

Question

True or False: Government spending is a tool used by the Fed

Show answer

Answer

False

Show question

More about Expansionary and Contractionary Monetary Policy
60%

of the users don't pass the Expansionary and Contractionary Monetary Policy quiz! Will you pass the quiz?

Start Quiz

Discover the right content for your subjects

No need to cheat if you have everything you need to succeed! Packed into one app!

Study Plan

Be perfectly prepared on time with an individual plan.

Quizzes

Test your knowledge with gamified quizzes.

Flashcards

Create and find flashcards in record time.

Notes

Create beautiful notes faster than ever before.

Study Sets

Have all your study materials in one place.

Documents

Upload unlimited documents and save them online.

Study Analytics

Identify your study strength and weaknesses.

Weekly Goals

Set individual study goals and earn points reaching them.

Smart Reminders

Stop procrastinating with our study reminders.

Rewards

Earn points, unlock badges and level up while studying.

Magic Marker

Create flashcards in notes completely automatically.

Smart Formatting

Create the most beautiful study materials using our templates.

Sign up to highlight and take notes. It’s 100% free.