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PERFECT COMPETITION, LONG-RUN ADJUSTMENT: A perfectly competitive industry undertakes a two-part adjustment to equilibrium in the long run. One is the adjustment of each perfectly competitive firm to the appropriate factory size that maximizes long-run profit. The other is the entry of firms into the industry or exit of firms out of the industry, to eliminate economic profit or economic loss. The end result of this long-run adjustment is a multi-faceted equilibrium condition that price is equal to marginal cost and average cost (both short run and long run).

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EXPANSIONARY MONETARY POLICY:

A form of monetary policy in which an increase in the money supply and a reduction in interest rates are used to correct the problems of a business-cycle contraction. In theory, expansionary monetary policy can include buying U.S. Treasury securities through open market operations, a decrease in the discount rate, and a decrease in reserve requirements. In theory, open market operations are the primary tool of expansionary monetary policy. Expansionary monetary policy is often supported by expansionary fiscal policy. An alternative is contractionary monetary policy.
Expansionary monetary policy is an increase in the quantity of money in circulation, with corresponding reductions in interest rates, for the expressed purpose of stimulating the economy to correct or prevent a business-cycle contraction and to address the problem of unemployment. In days gone by, monetary policy was undertaken by printing more paper currency. In modern economies, monetary policy is undertaken by controlling the money creation process performed through fractional-reserve banking.

The Federal Reserve System (or the Fed) is U.S. monetary authority responsible for monetary policy. In theory, it can control the fractional-banking money creation process and the money supply through open market operations (buying U.S. Treasury securities), a lower discount rate, and lower reserve requirements. In practice, the Fed primarily uses open market operations for this control.

An important side effect of expansionary monetary policy is control of interest rates. As the quantity of money increases, banks are willing to make loans at lower interest rates.

Open Market Operations

Open market operations are the buying and selling of U.S. Treasury securities as a means of controlling bank reserves, the money supply, and interest rates. This policy tool is directed by the Federal Open Market Committee and implemented by the Domestic Trading Desk of the New York Federal Reserve Bank. Because open market operations are flexible, easily implemented, and quite effective they are the Fed's primary monetary policy tool.

Expansionary monetary policy occurs when the Fed buys U.S. Treasury securities through open market operations. The Fed pays for these Treasury securities with bank reserves, which results in an increase in total amount of reserves held by the banking system. Banks are inclined to lend these extra reserves at lower interest rates, which increases checkable deposits and the money supply.

Discount Rate

The discount rate is the interest rate that the Federal Reserve System charges commercial banks for reserve loans. The Federal Reserve System was established in part to provide commercial banks on the brink of failing with reserve loans. The discount rate is officially set by the Federal Reserve Banks, subject to approval by the Board of Governors. In practice, though, changes in the discount rate are coordinated with other monetary policy actions.

Expansionary monetary policy occurs when the Fed lowers the discount rate. This makes it easier for commercial banks to borrow reserves from the Fed. As with open market operations, the additional bank reserves held by the banking system induces more loans at lower interest rates, which increases checkable deposits and the money supply.

However, because commercial banks do not undertake a great deal of reserve borrowing from the Fed, an increase in the discount rate alone is likely to have a limited impact on the money supply. For this reason, the discount rate is used primarily as a signal for other monetary actions, especially open market operations.

Reserve Requirements

Reserve requirements are rules by the Fed specifying the amount of reserves that banks must keep to back up deposits. Reserve requirements are generally in the range of about 10 percent of checkable deposits and 0 percent of savings deposits. The primary reason for reserve requirements is to maintain the stability of the banking system and to avoid bank panics and other problems created when banks run short of reserves. The Board of Governors has authority over setting reserve requirements.

Expansionary monetary policy occurs when the Fed lowers reserve requirements. This means banks have more reserves than needed to back up deposits. They can then use these extra reserves to make more loans at lower interest rates, which increases checkable deposits and the money supply.

Reserve requirements are an important part of the structure of the banking system. Banks commit to long-term, multi-year loans based on existing and expected reserve requirements. If the Fed changed reserve requirements frequently, then either the banking system will be unstable or banks will simply target the highest expected reserve requirements. For this reason, reserve requirements are seldom used as a monetary policy tool.

Stimulating The Economy

All three tools, used separately or together, increase the amount of money in circulation and reduce interest rates. This combination of extra money and lower interest rates stimulate the economy by inducing additional expenditures on aggregate production, especially consumption expenditures and investment expenditures. With greater aggregate production, more resources are used, employment is greater, and unemployment declines.

This is precisely the stimulation needed of the economy is in a business-cycle contraction or recession with high unemployment rates. It is also recommended if the economy appears to be headed toward a business-cycle downturn. In fact, because monetary policy does not affect the economy immediately, implementing expansionary monetary policy before the economy a contraction sets it is the preferred strategy. In this way the recession and higher unemployment are not just "fixed," but avoided completely.

Other Policy Options

Expansionary monetary policy is one of several stabilization policies available to the federal government to address business-cycle problems. Congress and the President can also get into the act of stimulating the economy through expansionary fiscal policy. Or the Federal Reserve can direct actions toward the inflationary problems through contractionary monetary policy.
  • Expansionary Fiscal Policy: An alternative means of stimulating the economy is expansionary fiscal policy. This includes an increase in government spending and/or a decrease in taxes. Both actions increase aggregate expenditures, aggregate production, and employment. Expansionary fiscal policy can be used to complement expansionary monetary policy or as an alternative.

  • Contractionary Monetary Policy: Monetary policy can also be used to address inflationary problems created by an overheated business-cycle expansion. Contractionary monetary policy is the opposite of expansionary monetary policy. It consists of selling U.S. Treasury securities through open market operations, raising the discount rate, and increasing reserve requirements. The resulting decrease in the money supply and increase in interest rates decreases aggregate expenditures, aggregate production, and thus reduces inflationary pressures.

<= EXPANSIONARY FISCAL POLICYEXPENDITURES MULTIPLIER =>


Recommended Citation:

EXPANSIONARY MONETARY POLICY, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2014. [Accessed: October 31, 2014].


Check Out These Related Terms...

     | monetary economics | monetary policy | contractionary monetary policy | open market operations | discount rate | reserve requirements | central bank | Federal Reserve pyramid | Board of Governors, Federal Reserve System | Chairman of the Board of Governors, Federal Reserve System | Federal Reserve Banks | Federal Open Market Committee | Federal Advisory Council |


Or For A Little Background...

     | fractional-reserve banking | banks | money | bank reserves | bank panic | business cycles | check clearing | money creation | macroeconomics | monetary base | monetary aggregates | unemployment | inflation | investment expenditures | consumption expenditures | macroeconomic goals | political views |


And For Further Study...

     | Federal Deposit Insurance Corporation | Comptroller of the Currency | barter | aggregate market | inflation | bank balance sheet | gross domestic product | circular flow | goldsmith money creation | fiscal policy | expansionary fiscal policy | contractionary fiscal policy |


Related Websites (Will Open in New Window)...

     | Federal Reserve System |


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