Expansionary Economic Policy

The economic policy of the state is a set of measures aimed at streamlining the course of economic processes to achieve the socially important goals. The primary purpose of the economic policy is to maximize the welfare of society. Besides the main objective, there is a set of the so-called applied economic objectives, such as the economic growth, full employment, price level, and national currency stability. However, there is no single view on the necessity of the state intervention in the economy. The economic theory distinguishes two opposite approaches to understanding the role of the state in the economy: classical and Keynesian.

“The Classics” believe that the economy is internally stable and state intervention will only undermine the mechanism of market competition, so it should be kept to a minimum. The state must protect and defend property rights, protect the country’s borders and the rights of citizens. In these circumstances, economic selfishness will force manufacturers to produce products that are in demand among buyers, trying to outdo their competitors by any parameters.

However, the Great Depression of 1929-1933 has shown that the market alone cannot cope with such problems as unemployment and the reduction in output. Therefore, J. M. Keynes has formed a new approach on the matter of governmental intervention in the economy According to it, only the economics of full employment can be considered effective. The reason for it is the lack of unemployment. Keynes considers the downside of the so-called “effective demand” to be in the people’s propensity to save. He formulated a psychological law, the essence of which is as follows: with the increase of income consumption also increases, but not to the same degree as an increased income). Therefore, it is necessary to compensate for this lack by an active economic policy. The economic policies of most of the Western countries were based on the Principles of Keynesian theory until about the mid 70-ies of the XX century. However, the excessive state intervention in the economy has led to the limitation of market principles. By the 1970s, the countries faced such challenges as the reduced efficiency of the economy and the pace of technological progress, the exacerbation of the crisis processes, inflation, social dependency, and bureaucracy. This situation has led to the search for alternatives to regulate economic life. Thus, the government has started to supplement and support the market, instead of completely regulating it.

In order to maintain the economy in the state of equilibrium, the government may utilize a variety of policies, particularly the fiscal and monetary ones. Therefore, in the case the goal of the economic policy is to stimulate the country’s economy, it is called expansionary policy. In the case it focuses on the fight against inflation, it is called the anti-inflationary policy. In particular historical circumstances, a state may carry out the industrial, agricultural, or employment policy. Depending on the goals, the methods of the fiscal and monetary policy that are required to achieve them will be selected. In particular, the problem of implementation of the expansionary economic policy is especially acute nowadays since the global economy still experiences the effects of the recent crisis. As a result, it requires stimulation. The following work is dedicated to the analysis of the prerequisites of both fiscal and monetary expansionary policy, as well as their possible influence on the country’s economy. 

The Expansionary Fiscal Policy

The Required Changes

The fiscal policy is one of the primary methods of the state intervention in the economy to reduce the fluctuations of the business cycles and provide a stable economic system in the short-term perspective. The primary instruments of fiscal policy are the revenues and expenditures of the state budget: taxes, transfers, and government purchases of goods and services. In particular, if the country is going through a depression or is in the process of economic crisis, the state may decide to implement the expansionary fiscal policy. In this case, the government needs to stimulate aggregate demand, supply, or both at once. In order to do that, ceteris paribus, the government needs to increase the size of its spending, particularly, by increasing the amount of goods and services that are purchased by it. Another way to increase spending is raising the transfers (the financial help for certain businesses) as it will cause a decrease in the costs per unit of production, leading to the growth of the aggregate supply. Therefore, the spending of the state has an impact on the aggregate demand that is similar to that provided by the investments. The final and the most important measure is the reduction of taxes, namely the income tax. In this case, the GDP of the country will be affected through the mechanism of the tax multiplier.

The Effect of the Expansionary Fiscal Policy

The government spending and transfers are the expenditures of the state budget while the taxes are the main source of the budget revenues. Therefore, an increase in the governmental spending and lowered taxes will raise the aggregate demand. Moreover, the lowered taxes increase the size of income and thus, raise the household savings. Similarly, the reduction of taxes increases the profitability of investments for the businesses. The increased savings and investment will lead to the growth of the capital accumulation rate. Moreover, the reduction of taxes will raise the net wages and increase the incentive to work, in the end. As a result, the unemployment level will decrease resulting in the growth of the production, and, therefore, the increased GDP. 

In general, the expansionary fiscal policy is aimed at overcoming the cyclical downturn of the economy in the short-term perspective and suggests an increase in the government spending, tax cuts, or a combination of these measures. In the longer term, the policy of the tax cuts could lead to the expansion of the supply of the production factors and the growth of the economic potential. The tax cuts and increased transfers lead to the growth of both aggregate demand and aggregate supply. Moreover, in addition to an increase in the aggregate output, there is also a decline in the price level; therefore, such policy can be used as a tool to combat both unemployment and inflation.

The Expansionary Monetary Policy

The monetary policy is a form of the indirect influence on the economy, based on the theoretical concepts of economists about the role of money in the economy and their impact on key macroeconomic parameters, such as economic growth, employment, prices, balance of payments. The modern theories of money are increasingly seen as an active factor of the reproduction process, and have become a crucial part of macro analysis. In practice, the monetary policy is usually performed by the central bank. One of the necessary conditions for the effective economic development is the formation of a clear mechanism of monetary control, which allows the central bank to influence the business activity and monitor the activities of commercial banks in order to achieve the stabilization of the currency, and, as a result, to ensure the sustainable growth of the national production, stable prices, high employment, and a balanced state budget. In the US, in order to meet the specific needs of the country’s complex economy and financial system, this role belongs to the Federal Reserve Bank (the Fed). The instruments of monetary policy (the methods of influence of the Federal Reserve Bank on the volume and structure of the money supply) allow changing the monetary base by monitoring the amount of refinancing and regulation of the reserve requirements. They include an open market operations, the regulation of the discount rate, and the manipulation with the required reserve. All of them are the tools of indirect regulation as their efficiency is closely related to the degree of the money market development. 

The Required Reserve

The required reserve is the amount of deposits that the commercial banks must keep in the form of the interest-free deposits at the Federal Reserve Bank. It is set as a percentage of the total deposits. In the modern conditions, the required reserve performs not only a function of deposit insurance but also is used for the implementation of the control and regulatory functions of the Federal Reserve Bank, as well as for the interbank payments. The higher the required reserve is, the smaller the proportion of funds that can be used by commercial banks for active operations is. Increasing the reserve requirement reduces the money multiplier and leads to a reduction in the money supply; therefore, it is one of the measures of the anti-inflationary policy. On the contrary, the reduced required reserve frees up a considerable amount of funds into the free circulation. Therefore, such measure is used by the Fed to increase the money supply through stimulating the country’s economy during its downfall. In practice, this tool is infrequently used because the procedure itself is of a bulky nature, and its effects are quite significant but difficult to measure. The main advantage of this tool in the regulation of the money supply is that it affects all the banks in the same way and has a significant impact on the money supply in general. However, this tool has more negative than positive effects as small changes in the volume of the money supply are difficult to achieve through the changes in the required reserve. Nevertheless, its existence ensures stability of the money multiplier; thus, it provides a better control over the money supply.

The Discount Rate

The regulation of the discount rate is usually referred to as the discount policy. The discount rate is the percentage, in accordance to which, the Fed provides loans to the commercial banks taking into consideration of their bills. Depository institutions sometimes borrow money from the reserve banks to cover the temporary shortages of liquidity. The Fed can influence the amount of refinancing by affecting the cost of credit (the discount rate). If the discount rate is increased, the amount of borrowing from the Fed is reduced. In turn, the lowered money supply reduces the amount of the operations of the commercial banks that are focused on providing the loans to economic entities. Moreover, the banks get more expensive credit, and, therefore, increase their interest rates on loans. Consequently, the money supply in the economy is reduced. Therefore, the growth of the discount rate is used in the context of the anti-inflationary policy when it is necessary to stop the process of the money devaluation. On the contrary, reducing the discount rate has the opposite effect and is used in the context of the expansionary monetary policy. Unlike the interbank credit, the loans of the Federal Reserve Bank are transferred on the reserve accounts of the commercial banks; they increase the total reserves of the country’s banking system. Therefore, the monetary base expands and forms the basis for the multiplicative changes in the money supply, thus, increasing the amount of money in the economy and stimulating it.

The Operations on the Open Market

Operations on the open market are widely used in the conditions of the developed stock market. This tool involves the operations with the government securities by the Federal Reserve Bank (mostly in secondary markets). These operations usually involve either short-term government bonds or treasury bills. In the case there is a need to stimulate the country’s economy, after the financial crisis or during its downfall, the Fed buys securities from a commercial bank, increasing the amount of the reserve account of that bank. Respectively, the banking system receives the additional money beginning the process of expansion of the money supply multiplier. The scale of the expansion will depend on what proportion of the increase in the money supply is distributed to cash and deposits: the more money goes into cash, the smaller the scale of monetary expansion is. If the Fed sells securities, the process is reversed.

The open market operations can be divided into two types: dynamic (designed to change the volume of the reserves and monetary base) and defensive (the purpose of which is the weakening of the impact of the other factors, such as the change in the amount of funds on the government accounts at the Fed, on the monetary base). In the case when there is no need in the significant changes in the money supply, the open market operations are reduced to buying or selling securities. However, as a rule, the two other types of transactions are carried out: – the repurchase agreements (repos); the Fed buys the securities under the agreement that the sellers will buy them back after some time, usually not more than a week. Repo is a temporary purchase and is considered the most effective way of conducting the operations that are expected to be reversed in the short-term perspective. Therefore, in the context of the expansionary monetary policy, they are used to achieve a short-term increase in the money supply through stimulating the economy without leading it to stagnation. In the case the Fed seeks to conduct a temporary sale on the open market, it resorts to the offsetting transactions (reverse repo), by selling the securities, stipulating the right of their redemption in the near future. In the context of the expansionary policy, this measure is used to avoid inflation.

The Effect of the Expansionary Monetary Policy

The actions of the Fed performed in the context of the expansionary monetary policy are aimed at stimulating the country’s economy on the stage of its downturn. It lies in the fact that the Fed provides banks with the excess of cash resources, which can be used for the low-cost loans, expanding consumer demand, and business investment. For this purpose, the Fed buys the government securities, thereby increasing the bank cash resources. The interest rates on bank loans are reduced increasing the amount of loans granted and the money supply, which ultimately leads to an increase in the aggregate demand and, therefore, the spending. Consequently, in the short-term perspective, the expansionary monetary policy results in an increased production level (and, therefore, the growth of GDP) and  reduced unemployment. However, in the long run, it may lead to the stagnation of production and increase in the unemployment level. As a result, the GDP will also decrease. Therefore, instead of the discretionary policy of regulating the money supply and money circulation, it is advisable to use the monetary targeting. The essence of it lies in the strict adherence to the rate of the monetary growth, which is determined on the basis of the past long-term trends of the dynamics in production, money supply, and their velocity. 

In conclusion, it is possible to say that in the context of the complexity of social and economic life, the market alone is unable to solve the vital problems of the society. In view of this idea, the state has a number of economic functions, which are determined by the needs of the normal functioning of the economy – the economic policy. The basis of the mechanism of the economic policy implementation is the state regulation of the economy as a system of legislative, executive, and supervisory nature, by using legal, administrative, economic, direct, and indirect methods. In particular, the expansionary economic policy is aimed at stimulating the country’s economy during its downfall. In general, it consists of the fiscal policy, which is conducted by the government, and the monetary policy, implemented by the central bank. Despite the use of different methods of influence, they have the same effect: the growth of GDP and the aggregate demand, as well as the reduction of the unemployment level. However, it should be noted that the exertive expansionary policy may have the negative results. In particular, the lowered taxes may lead not only to the increased economic potential of the country but also the overheat of the economy. On the other hand, the growth of the money supply may result in the increased inflation and stagnation of the economy. Therefore, it is possible to say that the expansionary measures are to be limited by the restrictive ones. Such an approach will allow maintaining the economy in the state of balance and will be a prerequisite for the welfare of the society, which, as was mentioned before, is the primary goal of any government.

Related essays