Expansionary monetary policy is the policy used by the central bank to increase the money supply, mainly by keeping a low required reserve ratio, low discount rate and an open market purchase of government securities by the central bank in open market. Expansionary monetary policy is used to solve some macroeconomic problems like high unemployment but it also can bring into inflation in the country. Firstly, Central bank can implement the expansionary monetary policy by lowering the required reserve ratio. A decrease in the required reserve ratio allows the central banks to have more deposits with the existing volume of reserves and hold more cash on hand (Tarver, 2015). The commercial banks no need to keep as much of their reserves at central bank. Thus, central bank can increase the amount of loans that given to their customers including both consumers and business. As a result, the money supply increases. Besides that, central bank can lower the discount rate in order to expand the money supply. When the discount rate decreases, it will encourage the commercial banks to borrow the money from central bank due to the low cost of borrowing which will result the increase in lending activity in the economy. Thus, the money supply increases because banks increase their borrowing from central banks. Not only that, central bank can expand money supply by purchasing the government securities from the individual or organization in the open market which will increase in reserves. As a result, the money supply increases (Balasubranamian, 2006).
In overall, a decrease in required reserve ratio, discount rate and open market purchase of securities by Central Bank in the open market will increase the money supply. An increase in money supply will cause the money supply curve shifts to the right, interest rate will decrease. A low interest rate will increase the investment form the individual or firms because the cost of borrowing is cheaper (“Effects of Expansionary Monetary Policy on Interest Rates”, 2017). Increase in investment will result in increase in aggregate expenditure or aggregate demand. This is because investment is one of the combinations of aggregate expenditure and aggregate demand. Thus, more outputs will be produced and aggregate output will increase. A high production of outputs mean the country almost fully utilised all the resources likes labour because all the firms need to hire more workers to maximize the outputs due to the high demand in the market. This will result in low unemployment rate because more jobs are created. As aggregate output increases, aggregate income will also increase. People with higher income are purchasing the goods and services which will result a stronger demand of products and there are many dollars chasing a few goods in the market. Thus, this will result inflation because overall price level increases. So, unemployment and inflation is a negative relationship. When the unemployment rate is low, the inflation is high and vice versa.
Contractionary monetary policy is the policy used by the Central Bank to decrease the money supply in the market. Besides, contractionary monetary policy is implemented by keeping high discount rate, high required reserve ratio and an open market sale of government securities by the Central Bank. This policy is carried out in order to overcome some macroeconomic problems likes high inflation in the economy but may cause rise in the unemployment (Amadeo, 2017). First of all, Central Bank exercises contractionary monetary policy by increasing the required reserve ratio. Increase in the required reserve ratio will allow the banks to have lesser deposits with the existing volume of the reserves. Hence, as banks have lesser deposits to make loans, the supply of money in the market will decrease. In addition, Central Bank also uses the tool of discount rate to decrease the money supply in the contractionary monetary policy. Central Bank will increase the discount rate in order to reduce the money supply. This is because when the interest rate that the others bank must pay the Central Bank to borrow from it become higher, also means that the cost of borrowing become higher (Staff, 2016). This action of Central Bank by raising the discount rate will discourage the banks to borrow money from it and persuading the banks to reduce borrowing. Since the banks reduce the borrowing from the Central Bank, commercial banks now have lesser money to lend and make loans to the market. This result is a decrease in the money supply. Furthermore, open market sale of securities is also one of the tools that used by the Central Bank in the contractionary monetary policy. The Central Bank sells the government securities to households and firms in the open market, which decreases in reserves and decrease in the amount of money supplied by an amount equal to the money multiplier times the change in reserves (Staff, 2014).
In short, higher required reserve ratio, higher discount rate and an open market sale of securities by the Central Bank will decrease the money supply in the market. When the money supply decrease, money supply curve will shift leftwards and the interest rate will increase when new equilibrium achieved. Besides, interest rates become higher will decrease the amount of investment since the cost of borrowing now become higher. When investment drops, the aggregate expenditure will decrease and the aggregate expenditure curve shifts downward since investment is one of the components of aggregate expenditure. Finally, the total output decrease when new equilibrium is achieved. This also result in the aggregate demand falls and the aggregate demand curve shift to the left. Hence, the price level also drops, which indicates that low inflation. This also can be explain by consumers do not have enough money to purchase economic resources since the money supply in the market drops and people hold less money (Vitez, n.d.). On the other hand, decrease in aggregate output also will raise the unemployment from slowing production and increasing interest rates (Mohr, n.d.). As the firms slow their growth rates, they will tend to hire fewer workers. Rising in the unemployment also decrease the demand for goods and services, making the aggregate demand falls more severely. The contractionary monetary policy stabilizes the prices in the economy as the inflation slows.
One of the real-world examples was seen in the United States during the Great Recession. The Federal Reserve started reducing its discount rate from 5.25% in June 2007 all the way to 0% by the end of 2008 due to the decreases in housing prices and the economy slowed. Not only that, The Federal Reserve also purchased the government securities from January 2009 until August 2014, for a total of $3.7 trillion due to the economy slowdown (“What are some examples of expansionary monetary policy?”, 2015).
During 1971-1972, Central Bank of Malaysia used the expansionary monetary policy to stimulate the expansion in the business activity by lowering the borrowing and lending rate of commercial banks. However, by the late 1972 to 1974, the economy was getting better due to the increase in export prices (“Welcome to UM Student Repository”, n.d.). The overall price increases and cause inflation. Thus, the Central Bank used the contractionary monetary policy to raise back the deposits and lending rate for commercial banks and finance companies to stabilise the effect.
For examples, Uganda is one of the countries that applied the contractionary monetary policy in their economy. Their main purpose of implementing this policy was to enable Uganda’s economy and circulation of money deal with the problems in the financial market. According to Rupiny (2011), the Uganda National Bureau of Statistics studies the prices of 276 items in Uganda was increases to determine inflation. Uganda was set a monthly 13 percent of discount rate for money commercial banks borrow from it. After Uganda applied the contractionary monetary policy in their country, the Central Bank is efficient to control the inflation that was presently at 12.5 percent to five percent about two years.