Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Expansionary monetary policy

In order to carry out an expansionary monetary policy, the central bank increases the money supply to reduce the interest rate in the money market. In

Figure 9-10, the central bank has increased the money supply from M₀ to M₁, which reduced the interest rate from i₀ to i₁.


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Figure 9-10: Expansionary monetary policy: the money market.


This reduction in the interest rate is going to affect aggregate demand in the economy in a number of ways:

Increased consumption (C): Reduced interest rates make borrowing cheaper and saving less attractive. Consumers respond by borrowing more for current consumption and by saving less, which also boosts

consumption. Furthermore, people on variable rate mortgages see their monthly repayments fall and have more disposable income to spend on consumption.


Increased investment (I): The interest rate reflects the opportunity cost of investment, so any fall in the interest rate boosts investment. That is, more investment projects yield a greater expected return than the market interest rate.


Increased net exports (NX): When a country lowers its interest rate, people are more reticent to keep their savings in that country. This reluctance reduces the demand for the domestic currency, which results in a depreciation of the currency in the foreign exchange markets. Buying the country’s exports is cheaper for foreigners, and buying imported goods is more expensive for residents. These effects act to increase net exports.

Consumption, investment and net exports are all components of aggregate demand (AD = C + I + G + NX), so expansionary monetary policy boosts AD. You can model the effect on the economy using the AD–AS model (see Figure 9-11).

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Figure 9-11: Expansionary monetary policy: AD–AS.

In a similar way to expansionary fiscal policy, expansionary monetary policy has boosted aggregate demand from AD₁ to AD₂, in the short run causing output and the price level to rise (a movement from point A to point B in Figure 9-11). Sticky prices in the short run mean that the price level hasn’t risen by much. In the long run, prices become more flexible and the SRAS curve shifts up and to the left, raising the price level and reducing output until eventually output is unchanged.

The caveat is that the increase in investment caused by the fall in the interest rate typically increases the capital stock, so LRAS may well also increase and shift to the right.