Expansionary Monetary Policy vs. Contractionary Monetary Policy

What Effects Does Monetary Policy Have?

Economic balance
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[Q:]I'm having a little trouble trying to understand expansionary monetary policies and contractionary monetary policies. Can you help explain what impact expansionary monetary policies and contractionary monetary policies have on the economy?

[A:] Thanks for your great question. Students first learning economics often have trouble understanding what contractionary monetary policy and expansionary monetary policy are and why they have the effects they do.

Generally speaking contractionary monetary policies and expansionary monetary policies involve changing the level of the money supply in a country. Expansionary monetary policy is simply a policy which expands (increases) the supply of money, whereas contractionary monetary policy contracts (decreases) the supply of a country's currency.

Expansionary Monetary Policy

In the United States, when the Federal Open Market Committee wishes to increase the money supply, it can do a combination of three things:
  1. Purchase securities on the open market, known as Open Market Operations
  2. Lower the Federal Discount Rate
  3. Lower Reserve Requirements
These all directly impact the interest rate. When the Fed buys securities on the open market, it causes the price of those securities to rise. In my article on the Dividend Tax Cut we saw that bond prices and interest rates are inversely related. The Federal Discount Rate is an interest rate, so lowering it is essentially lowering interest rates.
If the Fed instead decides to lower reserve requirements, this will cause banks to have an increase in the amount of money they can invest. This causes the price of investments such as bonds to rise, so interest rates must fall. No matter what tool the Fed uses to expand the money supply interest rates will decline and bond prices will rise.

Increases in American bond prices will have an effect on the exchange market.

Rising American bond prices will cause investors to sell those bonds in exchange for other bonds, such as Canadian ones. So an investor will sell his American bond, exchange his American dollars for Canadian dollars, and buy a Canadian bond. This causes the supply of American dollars on foreign exchange markets to increase and the supply of Canadian dollars on foreign exchange markets to decrease. As shown in my Beginner's Guide to Exchange Rates this causes the U.S. Dollar to become less valuable relative to the Canadian Dollar. The lower exchange rate makes American produced goods cheaper in Canada and Canadian produced goods more expensive in America, so exports will increase and imports will decrease causing the balance of trade to increase.

When interest rates are lower, the cost of financing capital projects is less. So all else being equal, lower interest rates lead to higher rates of investment.

What We've Learned About Expansionary Monetary Policy:

  1. Expansionary monetary policy causes an increase in bond prices and a reduction in interest rates.
  2. Lower interest rates lead to higher levels of capital investment.
  3. The lower interest rates make domestic bonds less attractive, so the demand for domestic bonds falls and the demand for foreign bonds rises.
  1. The demand for domestic currency falls and the demand for foreign currency rises, causing a decrease in the exchange rate. (The value of the domestic currency is now lower relative to foreign currencies)
  2. A lower exchange rate causes exports to increase, imports to decrease and the balance of trade to increase.
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Contractionary Monetary Policy

As you can probably imagine, the effects of a contractionary monetary policy are precisely the opposite of an expansionary monetary policy. In the United States, when the Federal Open Market Committee wishes to decrease the money supply, it can do a combination of three things:
  1. Sell securities on the open market, known as Open Market Operations
  2. Raise the Federal Discount Rate
  1. Raise Reserve Requirements
These cause interest rates to rise, either directly or through the increase in the supply of bonds on the open market through sales by the Fed or by banks. This increase in supply of bonds reduces the price for bonds. These bonds will be bought up by foreign investors, so the demand for domestic currency will rise and the demand for foreign currency will fall. Thus the domestic currency will appreciate in value relative to the foreign currency. The higher exchange rate makes domestically produced goods more expensive in foreign markets and foreign good cheaper in the domestic market. Since this causes more foreign goods to be sold domestically and less domestic goods sold abroad, the balance of trade decreases. As well, higher interest rates cause the cost of financing capital projects to be higher, so capital investment will be reduced.

 

What We've Learned About Contractionary Monetary Policy:

  1. Contractionary monetary policy causes a decrease in bond prices and an increase in interest rates.
  1. Higher interest rates lead to lower levels of capital investment.
  2. The higher interest rates make domestic bonds more attractive, so the demand for domestic bonds rises and the demand for foreign bonds falls.
  3. The demand for domestic currency rises and the demand for foreign currency falls, causing an increase in the exchange rate. (The value of the domestic currency is now higher relative to foreign currencies)
  1. A higher exchange rate causes exports to decrease, imports to increase and the balance of trade to decrease.
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