Expansionary Monetary Policy

Expansionary monetary policy (Cheap Money Policy/Easy Money Policy) is a type of monetary policy used by a central bank to stimulate economic activity by increasing the money supply, lowering interest rates and boosting aggregate demand.

Objectives

• Stimulate Economic Growth: Central banks lower interest rates to make borrowing cheaper for businesses and consumers, driving up investment and consumer spending.
• Encourage Investment: Lower borrowing costs make it cheaper for businesses to take loans, start new projects and expand production.
• Increase Consumption: Cheaper and more easily available credit encourages people to spend more on goods and services.
• Reduce Unemployment: Higher consumption and investment increase demand for goods and services, encouraging businesses to produce more and hire more workers.
• Counter Deflationary Pressures: Stronger aggregate demand helps prevent persistent decline in the general price level.

Instruments of Expansionary Monetary Policy

1. Reduction in Policy Interest Rate

• The central bank lowers its policy interest rate, making borrowing cheaper and encouraging consumption and investment.
• India → RBI reduces the Policy Repo Rate
  • Repo Rate ↓ → Lending Rates tend to ↓ → Borrowing ↑ → Consumption & Investment ↑ → Aggregate Demand ↑

2. Reduction in Bank Reserve Requirements

• The central bank can reduce the reserve requirements imposed on banks, leaving banks with more funds available for lending and credit creation.
  • Reserve Requirements ↓ → Funds Available with Banks ↑ → Lending Capacity ↑ → Credit Creation ↑
• India: A reduction in the Cash Reserve Ratio (CRR) releases funds that banks would otherwise maintain with the RBI.
  • CRR ↓ → Cash Reserves with RBI ↓ → Funds Available with Banks ↑ → Lending Capacity ↑ → Credit Creation ↑

3. Open Market Purchases

• The central bank can purchase government securities in the open market, thereby injecting liquidity into the financial system.
  • Central Bank Purchases Government Securities → Funds Enter Banking/Financial System → Liquidity ↑
• India: The RBI conducts Open Market Operations (OMOs) involving outright purchases and sales of government securities to manage durable liquidity.
  • RBI Purchases G-Secs → Money/Liquidity Injected into Banking System → Availability of Funds ↑

Direction of Monetary Policy Instruments

During monetary easing, the following changes generally have an expansionary effect:

• Repo Rate ↓ → Borrowing from RBI becomes cheaper → Credit conditions ease
• Bank Rate ↓ → Borrowing from RBI becomes cheaper
• MSF Rate ↓ → Overnight borrowing from RBI under MSF becomes cheaper
• SDF Rate ↓ → Return on funds parked with RBI ↓ → Parking surplus funds with RBI becomes relatively less attractive
• CRR ↓ → Banks maintain less cash with RBI → Funds available for lending ↑
• SLR ↓ → Smaller proportion of deposits required to be maintained in specified liquid assets → More funds potentially available for lending
• Reverse Repo Rate ↓ → Parking surplus funds with RBI becomes relatively less attractive → Encourages deployment of funds elsewhere
• OMO Purchase of Government Securities → RBI purchases G-Secs → Liquidity injected into the banking system

Impact on the Economy

• Economic Growth: Higher consumption and investment increase aggregate demand and support economic activity.
• Investment: Lower borrowing costs encourage firms to undertake new investment.
• Consumption: Cheaper credit encourages household expenditure.
• Employment: Higher demand encourages businesses to increase production and employment.
• Credit Growth: Easier monetary conditions tend to increase demand for and availability of credit.
• Inflation: As aggregate demand increases, inflationary pressures can rise, particularly when the economy is operating close to its productive capacity.
• Exchange Rate: Lower interest rates can contribute to currency depreciation, which can support exports but also increase the domestic cost of imported goods and inputs.

Expansionary vs Contractionary Monetary Policy