Any government policy aimed at stimulating aggregate output (income) (Y) is said to be expansionary.
An expansionary fiscal policy is an increase in government spending (G) or a reduction in net taxes (T) aimed at increasing aggregate output (income) (Y).
An expansionary monetary policy is an increase in the money supply aimed at increasing aggregate output (income).
Expansionary Fiscal Policy: An Increase in Government Purchases (G) or a Decrease in Net Taxes (T)
~Government purchases (G) and net taxes (T) are the tools of government fiscal policy. The government can stimulate the economy-this is, it can increase aggregate output (income) either by increasing government purchases or by reducing net taxes. Though the impact of a tax cut is somewhat smaller than the impact of an increase in G, both have a multiplier effect on the equilibrium level of Y.
~Consider an increase in government purchases (G). This increase in expenditure causes the firm’s investors to be smaller than planned. Unplanned inventory reductions stimulate production, and firms increases output (Y).
~However, because added output means added income, some of which is subsequently spent, consumption spending (C) also increases.
~Again inventories will be smaller than planned and output will rise further. The final equilibrium level of output is higher by a multiple of the initial increase in government purchases.
~As aggregated output (income) increases an impact is felt in the money market-the increase in income (Y) increases the demand for money (Md). the resulting disequilibrium, with the quantity of money, demanded greater than the quantity of money supplied, causes the interest rate to rise. The increase in G increases both Y and r
~ The increase in r has the side effect- a high-interest rate causes planned investment spending (I) to decline. Because planned investment spending is a component of planned aggregate expenditure (C +I +G), the decrease in I works against the increase in G. an increase in government spending (G) increases planned aggregate expenditure and increases aggregate output, but a decrease in planned investment reduces planned aggregate expenditure and decreases aggregate output.
~This tendency for increases in government spending to cause reductions in private investment spending is called the crowding effect. Without any expansion in the money supply to accommodate the rise in income and increased money demand, planned investment spending is partially crowded out by the higher interest rate.
~The extra spending created by the rise in government purchases is somewhat offset by the fall in planned investment spending. Income still rises, but the multiplier effect of the rise in G is lessened because of the higher interest rates’ negative effect on planned investment.
Expansionary Monetary Policy: An Increase in the Money Supply
~Consider if the Fed decides to increase the supply of money through open market operations. First, open market operations inject new reserves into the system and expand the quantity of money supplied. Because the quantity of money supplied is now greater than the amount households want to hold, the equilibrium rate of interest falls. Planned investment spending (which is composed of planned aggregate expenditure) increases when the interest rates fall.
~Increased planned investment spending means planned aggregate expenditure is now greater than aggregate output. Firms experience unplanned decreases in inventories and they raise output (Y).
~An increase in money supply decreases the interest rate and increases Y. However, the higher level of Y increases the demand for money (the demand for money curve shifts to the right) and this keeps the interest rate from falling as far as it otherwise would.
~The link between the injection of the reserve by the Fed into the economy and the increase in the output is, first, the increase in the money supplied pushes down the interest rates.
~ Second, the lower interest rate causes planned investment spending to rise.
~ Third, the increased planned investment spending means planned aggregate expenditure, which means increased output as firms react to unplanned decreases in inventories.
~Fourth, the increase in output (income) leads to an increase in the demand for money (the demand for money curve shifts to the right) which means the interest rates decrease less than they would have if the demand for money had not increased.
Effects of Expansionary monetary policy
~An expansionary monetary policy is to do with an increase in money supply which tends to have the following effects on an economy:
i) Inflationary tendencies – an increase in money supply arising from an expansionary monetary policy such as a reduction in the bank rate and therefore an increase in the lending capacity of commercial banks, is likely to cause inflation, particularly where such an increase is inconsistent with the short[1]run productive capacity.
ii)Disincentive to investment – a fall in the relative value of a domestic currency discourages investment potential due to:
~An increase in the cost of inputs (increase in production costs) reduces profits.
~A fall in purchasing power and effective demand again reduces profits through the intermediary of downward pressure on the overall business turnover.
iii) Increase in cost of capital – an expansionary monetary policy tends to increase the level of interest rates whose extreme effects include the banking crisis manifestations such as the disproportionately large amount of non-performing loans ( or even bad debt portfolio), statutory management, branch network closures and sometimes liquidation.
~However, where the expansionary monetary policy arises during a situation of low economic activity (recession), the tendency would be a fall in interest rates and an increase in the equilibrium level
Thanks for reading this article. Have a fruitful day, won’t you!!!