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.

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.

Fig. 1 - Expansionary policy graph

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.

Fig. 2 - Contractionary Monetary Policy

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.

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.