Expansionary monetary policy is an approach to governmental interference in economics that focuses on encouraging growth. This approach is essential to Keynesian economics and frequently sees use during recessions. The central idea of expansionary monetary policies is to generate additional demand through direct government spending or increased lending. It is based on the assertion that businesses cannot expand because people are not buying enough of their goods. As such, by increasing consumers’ buying power and purchasing various products themselves, the government injects money into the economy. The expectation is that companies will put this cash influx to use and continue expanding, fueling growth.
Figure above illustrates the effects of expansionary monetary policy, as well as some complications that may arise, using the AD-AS model. Initially, the aggregate demand is on the AD0 curve, with output reaching the Y* level where it intersects the AS0 curve. Next, the Fed decides to increase demand by introducing additional money into the economy and lowering interest rates. As a result, the aggregate demand is now on the E1 curve, and its new intersection with the AS0 curve creates a new equilibrium with higher output. The task of expanding the economy has been completed successfully, at least in theory.
However, complications arise when banks become involved, as they can anticipate the Fed’s actions to a degree and use them to their advantage. Goodwin et al. note that “economists of the rational expectations school predict that actors in the private economy will anticipate this expansionary move [… and] immediately raise their inflationary expectations.” As a result, aggregate supply increases and now occupies the AS1 curve, which intersects with AD1 in the E1 point. The same output characterizes this point as E0, which would mean that the Fed has increased the Inflation rate but achieved nothing otherwise.