Expansionary Policy Definition Examples Top 4 Tools

Expansionary Policy Definition

Expansionary policy is defined as an economic policy during which the government increases the money supply in the economy using budgetary tools like increasing government spending and cutting the tax rate to increase disposable income primarily to tackle economic slowdowns and recession.

Understanding of Expansionary Policy

Expansionary policy boosts the aggregate demand by infusing more money into the economy. The following methods do expansion of cash:

Creating demand in the market by raising the disposable incomeDisposable IncomeDisposable income is an important mechanism to measure household incomes, and includes all sorts of income such as wages and salaries, retirement income, investment gains. In other words, it is the amount of money left after paying off all the direct taxes.read more of consumers through tax rate cuts.Increasing the companies Profit After Tax (PATPATProfit After Tax is the revenue left after deducting the business expenses and tax liabilities. This profit is reflected in the Profit & Loss statement of the business.read more) of the companies by cutting the business taxes will boost business investment.Increasing spending by the government to create demand in different sectors and provides additional grants to state and local governments to increase their expenditures on final goods and services.

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Expansionary Policy Examples

Following are the examples of expansionary policy.

Example #1

U.S congress to develop suitable fiscal policiesFiscal PoliciesFiscal policy refers to government measures utilizing tax revenue and expenditure as a tool to attain economic objectives. read more for Utah which has 3% inflation, 8% unemployment, 1% GDP growth rate and 5% budget surplus. So as an economic advisor to U.S Congress Mr. Adams analyzed that Utah has low inflation, high unemployment, low GDP growth, and high a budget surplusA Budget SurplusA budget surplus occurs when the government’s earnings through tax revenues is more than its spending in the current quarter or year. A government surplus is a positive sign in an economy because it demonstrates the government’s earning power.read more. It signifies that Utah is currently in the economic cycle’s recession phase and needs a boost to reverse the cycle.

So Mr. Adams prepared an expansionary policy in which, seeing the high budget surplus, suggested tax cuts and suggested the federal government increase their expenditure in sectors that increase demand in the market and create employment opportunities.

Example #2

Another example of the expansionary monetary policyExpansionary Monetary PolicyThe central bank uses expansionary monetary policy to increase the supply of money while lowering the interest rate and increasing demand. This is done to boost a country’s economy.read more was during the great recession in the USA. When the housing price was reduced to a new level, and the economy was also significantly slow, the federal reserve started reducing its short-term borrowing rate from 5.25% in mid of 2007 to 0% by the end of December 2008. The economy still didn’t reflect any sign of recovery, so the federal reserve started purchasing government securities and bonds from Jan 2009 onwards by infusing billions of dollars into the economy.

Tools of Expansionary Policy

Expansionary policy tools as follows –

Reduction in Short-term Interest Rates – Central banks cut the rates at which commercial banks take loans from them to meet their liquidity shortages. So this gives commercial banks scope to cut down interest rates they charge against the short-term loansShort-term LoansShort-term loans are defined as borrowings undertaken for a short period to meet immediate monetary requirements.read more.Reduction in Reserve Requirements – Central banks will reduce the amount needed by commercial banks as a reserve. It will provide more liquidity to banks, leading to an increase in loanable funds.Buy-Back of Securities – The government may decide to buy back many government-issued securities and bonds from Domestic and Institutional investorsInstitutional InvestorsInstitutional investors are entities that pool money from a variety of investors and individuals to create a large sum that is then handed to investment managers who invest it in a variety of assets, shares, and securities. Banks, NBFCs, mutual funds, pension funds, and hedge funds are all examples.read more to infuse more liquid funds into the economy.Increase in Public Expenditure – The government has various policies and relief packages for different sectors to boost the economy and attract more investment.Tax Cuts – Government with an idea of creating demand by increasing the disposable income cut down the Individual taxes and Business taxes.

Effect of Expansionary Policy

Effects of an expansionary policy on the interest rate and aggregate demandAggregate DemandAggregate Demand is the overall demand for all the goods and the services in a country and is expressed as the total amount of money which is exchanged for such goods and services. It is a relationship between all the things which are bought within the country with their prices.read more are as follows-

#1 – On Interest Rate

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As shown in the figure, the original equilibrium (E0) occurs when borrowing of $10 billion was provided at an interest rate of 8%. An expansionary monetary policy by the government will increase the supply of the fund hence shifting the supply of loanable funds to the right from S0 to S1, leading to shifting in equilibrium towards the right to position E1 where more loans are available at a low-interest rate. Vice versa will be the scenario in case of contractionary economic policy that will reduce the cash in the Economy and reduce the supply of loanable funds that will make borrowing expensive.

#2 – On Aggregate Demand

An expansionary policy increases the number of loanable funds with the banks, leads to a reduction of interest rate, and policy, when coupled with the tax rate cut, increases the money in the pocket of consumers. More disposable income will increase the purchasing power of the consumers and will create demand in the market.

Advantage

Given below are the advantages of expansionary policy.

Multiplier Effect – More government spending leads to the inflow of more money in the hand of the public. Policies like tax rate cuts also increase their disposable income, leading to additional spending and demand and economic growth.Increase in Investment – Expansionary Policy means an increase in Government Investment. Under this government put money in the downsized and cash-constrained businesses and provided stimulus to the business. Private investment gradually picks up as fund infusion from the government will stimulate growth in the sector.Decrease in Unemployment – Expansionary Policy increases private and public investment, which creates a demand in the market. So, to meet demand, production shifts are increased, which leads to more employment generation.

Disadvantages

Given below are the disadvantages of expansionary policy.

Increase in Inflation – The inflow of more money in the economy will increase inflation. If the inflow is not monitored properly, that can lead to high inflation, negatively impacting the economy. Inflation is good up to some level.Currency Devaluation – The higher inflow of currency will reduce the value of the currency that can put an additional burden on the import expenditure of the economy.Crowding Out – Expansionary Policy could lead to falling in investment in the private sectorPrivate SectorThe private sector is a section of the national economy that the government does not own. The business conducted under this sector is carried out by companies or entrepreneurs who focus on profit maximization and customer satisfaction.read more because investors generally prefer government debt over corporate debt because they are a safe investment. Under the expansionary policy, the government needs more funds to and so in order to attract investors will issue bonds at a higher interest rate, this will reduce the demand for corporate debt and will hurt the private sector.

Conclusion

Expansionary Policy is the type of macroeconomic policy used by the government to push economic growth and increase investment and aggregate demand. It is the remedy given by Keynesian economicsKeynesian EconomicsKeynesian Economics is a theory that relates the total spending with inflation and output in an economy. It suggests that increasing government expenditure and reducing taxes will result in increased market demand and pull up the economy out of depression.read more to be used during the economic slowdown to push the economy out of recession.