The Purpose of Expansionary Monetary PolicyExpansionary monetary policy is used to ward off the contractionary phase of the business cycle. However, it is difficult for policymakers to always catch this in time. Therefore, you will most often see expansionary policy used after a recession has already started. To stimulate demand, the Federal Reserve lowers costs by reducing bank lending rates. This makes auto, school and business loans, as well as home mortgages, less expensive. This is usually enough to stimulate demand, and drive economic growth to a healthy 2-3% rate.
How Does the Federal Reserve Carry Out Expansive Monetary Policy?The Fed has many tools to expand the money supply. Its first instinct is to reach for the Fed funds rate. This is the rate banks charge each other for overnight deposits. The Fed requires banks to keep a certain amount of their deposits in reserve at their local Federal Reserve branch office every night. Those banks that have more than they need will lend the excess to banks who don't have enough, charging the Fed funds rate. When the Fed drops the target rate, it becomes cheaper for banks to maintain their reserves, giving them more money to lend. As a result, banks can lower the interest rates they charge their customers.
If this doesn't stimulate the economy enough, the Fed will reach for its next more powerful tool, open market operations. That's when the Fed buys Treasury notes or even mortgage-backed securities from its member banks. Where does it get the funds to do so? The Fed simply creates the credit out of thin air. This is what people mean when they say the Fed is printing money.
This pumps more money into bank coffers, giving them more to lend. This is also known as quantititative easing. In 2011, the Fed created Operation Twist. When its short-term notes came due, it sold them and used the proceeds to buy long-term Treasury notes. This lowered long-term interest rates, making mortgages more affordable.
The third tool the Fed has is lowering the discount rate. That's what it charges banks who borrow from its discount window. However, banks rarely use the discount window because there is a stigma attached. The Fed is considered to be a lender of last resort. Banks only use the discount window when they can't get loans from any other banks. Banks hold this viewpoint, even though the discount rate is usually lower than the Fed funds rate. Nevertheless, the Fed usually drops the discount rate when it lowers the target for the Fed funds rate.
The Fed hardly ever uses its other tool, lowering the reserve requirement. Even though this immediately increase liquidity, it also requires a lot of new policies and procedures for member banks. It's much easier to lower the Fed funds rate, and it's just as effective. (Source: The Federal Reserve Bank of San Francisco, Federal Reserve Tools)
Under the leadership of Federal Reserve Chairman Ben Bernanke, the Fed created an alphabet soup of innovative tools to combat the 2008 financial crisis. They were all ways to pump more credit into the financial system. The TAF, or Term Auction Facility, allowed banks to sell their subprime mortgage-backed securities to the Fed. In conjunction with the Treasury Department, the Fed offered TALF, or Term Asset-Backed Securities Loan Facility, which did the same for financial institutions holding subprime credit card debt.
In response to a destructive run on money market funds on September 19, 2008, the Fed established the AMLF, or Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility. This program loaned $122.8 billion to banks then lend to money market funds. In October, the Fed created the MMIFF, or Money Market Investor Funding Facility, which lent directly to the money markets themselves.
The good news is that the Fed reacted quickly and creatively to stave off financial collapse. The credit markets had frozen up, and without this decisive response the day-to-day cash that businesses use to keep running would have gone dry. The bad news is that the public did not understand what the programs did, so became suspicious of the Fed's motives and power. This led to a drive to have the Fed audited, which was partially fulfilled by the Dodd-Frank Wall Street Reform Act.
Can There Be Too Much Expansionary Monetary Policy?If the Fed stimulates too much, then it risks triggering inflation. That's when prices rise more than the Fed's 2% inflation target. The Fed sets this target to stimulate healthy demand. When consumers expect prices to increase gradually, they are more likely to buy more now.
The trouble starts when inflation gets higher than 2-3%. Consumers start stocking up to avoid higher prices later. This drives demand faster, which triggers businesses to produce more, and hire more workers. The additional income allows people to spend more, stimulating more demand. Sometimes businesses start raising prices because they know they can't product enough. Other times, they raise prices because their costs are rising. If it spirals out of control, it can create in hyperinflation. That's when prices rise 50% or more -- a month! (For more, see Types of Inflation.)
To stop inflation, the Fed puts on the brakes by doing the opposite, and instituting contractionary monetary policy, also known as restrictive monetary policy. The Fed raises interest rates, and sells its holdings of Treasuries and other bonds. This reduces the money supply, restricts liquidity and cools economic growth. The Fed's goal is to keep inflation near its 2% target, while keeping unemployment low as well. Article updated June 28, 2012