Expansionary Monetary Policy: Helping the Economy Grow

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  • 0:03 Introducing…
  • 1:34 Three Main Goals of…
  • 3:01 Three Tools of…
  • 6:35 How Expansionary…
  • 8:45 Lesson Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

In this lesson, you'll learn how the central bank helps the economy grow during recessions by increasing the size of the money supply. An overview of the three tools of monetary policy are included as well as the reasons why monetary policy leads to higher economic output.

Introducing Expansionary Policy

It's a Saturday night in the big city. Although the downtown area is still busy with people having fun, economic output has been falling for the last nine months. People have stopped spending a lot of money and are trying to find ways to cut their budget. In order to preserve their profits, companies have had to lay off employees, and roughly ten percent of the labor force doesn't have a job right now. This is the all-too-familiar villain called 'recession.'

When times get tough in the big city, the mayor turns on a powerful night projector and illuminates the sky with a gigantic symbol of the all-seeing eye on top of the pyramid. When the central bank sees the emergency light illuminating the night sky, it comes to the rescue with what economists call 'expansionary monetary policy,' like a superhero on an assignment to take down a master criminal. Let's take a closer look at what expansionary monetary policy is and how the central bank uses it to stimulate economic growth and fight the enemy called recession.

Three Main Goals of the Federal Reserve

The Federal Reserve, which is the nation's central bank, has total control over the money supply. The government has delegated this authority to them in order to achieve the goals of:

  1. Sustainable economic growth
  2. High employment
  3. Stable prices

Now, they're constantly monitoring the economy using various indicators, and either they add money or remove money from the money supply. As it turns out, the government delegated this authority because central bankers actually have superpowers. As it turns out, central bankers were born on a planet with a red sun. While under the rays of a yellow sun here on Earth, however, superpowers arise - such as the power to create money out of thin air!

Expansionary monetary policy is a policy by monetary authorities to expand the money supply, which boosts economic activity by keeping interest rates low to encourage borrowing by companies, individuals and even banks. Like a superhero, the central bank will likely use this type of policy whenever the economy is forecasted to enter a recession.

Three Tools of Expansionary Monetary Policy

The central bank uses three main tools to conduct expansionary monetary policy. They include:

  1. Buying U.S. Treasury securities in the open market (which we call 'open market operations')
  2. Reducing the reserve requirement
  3. Lowering the discount rate

So let's talk about these. They keep interest rates low by expanding the money supply through open market operations. Specifically, they buy U.S. Treasury securities in the open market. In addition, the Fed can lower the amount of reserves that it requires commercial banks to hold. That's called reducing the reserve requirement. Finally, it can reduce the rate that it charges banks who wish to borrow directly from the central bank. This is called lowering the discount rate.

All three of these tools - used separately or together - will increase the amount of money in circulation, which will reduce interest rates and stimulate economic growth. During the Great Recession, the Federal Reserve cut interest rates dramatically in an effort to boost economic growth. Beginning in September 2007, in a series of ten moves, the federal funds target was reduced from 5.25% to a range of 0% - 0.25% on December 16, 2008. Here's how they described their response to the economic downturn, including the tools they used during this time. Here's what they said:

'The financial crisis that began in 2007 was the most intense period of global financial strains since the Great Depression, and it led to a deep and prolonged global economic downturn. The Federal Reserve took extraordinary actions in response to the financial crisis to help stabilize the U.S. economy and financial system. These actions included reducing the level of short-term interest rates to near zero. To provide further support for the U.S. economy, the Federal Reserve has purchased large quantities of longer-term Treasury and government agency securities in an effort to further reduce longer-term interest rates. Low interest rates help households and businesses finance new spending and help support the prices of many other assets, such as stocks and houses.'

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