Expansionary monetary policy

Expansionary policy is the government following policies that include fiscal or monetary measures in an attempt to stimulate the economy. Governments can then lower lending rates, invest in public services to create jobs, or reduce public debt through the impact of future tax revenues and consumption .

From classic to Keynesian

In modern society, a lot of different things can have a direct or indirect impact on the macroeconomic environment. A part of the macroeconomics thinks that we should let the economy regulate itself and not influence the market with policy because that has for only result the global increase of the prices or inflation. For others who follow the Keynesian theory, a good monetary policy can positively influence the real output. Indeed, that allows to increase the demand and so the offer. That restores the economic growth. In General Theory, Keynes redefined the basic tenets of the Quantity Theory of Money. It states that money is neutral in equilibrium, and that output, relative prices, and incomes are independent of the money supply. This position stands in stark contrast to his earlier work which argued that quantification was valid, al be it somewhat vague, especially in the short run when imbalances occured. He rejected the belief that decentralized market systems are inherently stable. This is because the inherent uncertainty of the future has been fueled by the "animal spirit" of investors, and a centralized decision-making process is preferable to the decentralized one, prevalent in market economies. Keynes expressed his support for "widespread socialization of investment" to achieve full employment. Interest rates, in Keynes' view, need to be kept low (or pushed down to 0%) to avoid capital crisis and create a fairer economy. Keynes believed that once the scarcity problem was solved, future generations would be able to abandon economics and choose a life filled with aesthetic pleasures .

Correlation between monetary expansion and inflation

Another consequence is the increasing of the inflation and it’s due to the positive correlation between inflation and the level of output. But for a good economic growth, it is required to maintain the level of consumption and investment.Inflation is not a problem if it remains under control. The central bank of the European-Union targets a level of 2%for example. That guarantees a good and controlled growth of the economy .

Monetary expansion to prevent deflation

The biggest goal of a monetary expansion is to avoid a dangerous deflation. Deflation can lead to big economic crisis like in the USA between 1873 and 1896 or the great depression of the 1930s. For a lot of participants of financial markets, it is considered as the most feared risks. Indeed, deflation involve less consumption at all because customers are waiting for cheaper goods, so they delay their consumption. Therefore, that will stop the global demand. Due to this, factories will produce less and so cutting staff. There will be a lot of unemployment and an increase in poverty. All these things lead to vicious and extremely dangerous circle for all the economy .

Potential issue with a monetary expansion

One thing to watch out with this policy is the liquidity trap. In a case of liquidity trap the monetary policy is ineffective. That can happen in the following case :

• A nominal interest rate of zero means that the real rate of return for nominal bonds and money is the same. Therefore, money, more than outstanding balances, is a perfect substitute for bonds, and the private sector is indifferent to holding bonds and surplus money. Expansionary open market operations where central banks buy bonds and increase the monetary base do not affect nominal and real prices and volumes. The private sector holds an increased cash base in lieu of bonds. In that case, monetary policy has no effect at all. This is true at least as long as government bonds are issued, and as long as expectations are trending toward deflation and the private sector believes that will continue.
• In an open economy with floating exchange rates, the exchange rate channel of the transmission mechanism can increase the impact of monetary policy measures, make the non-negative constraint on nominal interest rates less binding, and increase the likelihood of avoiding a liquidity trap.

Policy mix

To generate a bigger impact on the macroeconomic environment, policymakers often use a policy mix. A policy mix is a combination of monetary and fiscal policy. The fact is that it is not the same institutions which manage these 2. Monetary decisions come from the central bank and fiscal decisions are taken by political institutions. The central bank is independent from the politics, that guarantees impartial and transparent decisions. Fiscal policy, by contrast, is carried out by political bodies such as governments and parliaments, whose mandates are limited and whose objectives are less clearly stated than monetary authorities. Mechanisms aimed at containing credibility problems that currently affect the course of policy decisions are imperfect at best when it comes to fiscal policy. As a result, monetary authorities are subject to constraints that central banks are unlikely to face.The two competent bodies have therefore the possibility of reducing or accentuating the effects of the policies pursued by the other .

Footnotes

Expansionary monetary policy — recommended articles

Interventionism — Galloping inflation — Money emission — Monetarism — Price stability — Austrian business cycle theory — Inflation target — Global demand — Austrian theory of money

References

• Gnocchi S. (2013) Monetary commitment and fiscal discretion: The Optimal Policy Mix, American economic journal, United States
• Henry F., Quiggin J. (2017) Consensus, Dissensus, and Economic Ideas: Economic Crisis and the Rise and Fall of Keynesianism, International Studies Quarterly, Volume 61, Issue 2, England
• Matthias F., Francis A., Hanno L. (2013) Deflation Risk,The Review of Financial Studies, England
• Ricardo R. (2017) Is something really wrong with macroeconomics?,Oxford University Press and Oxford Review of Economic Policy Limited, England
• Tomislav Ć., Hrvoje Š., Milan D. (2015) Monetary and fiscal policy mix in a small open economy: the case of Croatia, Economic Research-Ekonomska Istraživanja, Croatia

Author: SACRE Antoine