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Expansionary/Contractionary Policy and the Multiplier Effect

Expansionary/Contractionary Policy and the Multiplier Effect

Author: Kate Eskra
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This lesson covers the Expansionary/Contractionary Policy and the Multiplier Effect
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Tutorial

EXPANSIONARY/CONTRACTIONARY POLICY AND THE MULTIPLIER EFFECT

Source: Image of Expansionary Monetary Policy created by Kate Eskra, Image of Contractionary Monetary Policy created by Kate Eskra

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Hi. Welcome to Macroeconomics. This is Kate. This tutorial is on expansionary and contractionary policy and the multiplier effect. As always, my key terms are in red and examples are in green.

So in this tutorial, we'll discuss the goals of the Fed. We'll talk about the policies that the Fed can undertake when the economy is in a recession and when it's experiencing inflation. And finally, you'll understand how monetary policy works to speed up or slow down the economy.

So the Federal Reserve's main goals in managing our nation's money supply are the exact same goals as the federal government has in fiscal policy. And that's to promote full employment and price stability. But here in this tutorial, we're focusing on the actions of the Fed not the federal government.

So we're looking at monetary policy, which is typically policy set by a central banking authority where money supply access and the interest rate is varied to assist in stabilizing economic activity. So the Fed has different tools than the federal government does. It's our Federal Open Market Committee that meets several times a year to manage our nation's money supply.

And the tools that they use, we're going to talk about all of them. They're the reserve requirement, open market operations, the Fed funds market, and the discount rate.

Let's start with the reserve requirement. So we need to remind ourselves what this fractional reserve system is all about. Reserves are the portion of deposits required to be held by a bank. And they're usually kept to maintain reserve requirements, like we said, as set by the Fed.

So that reserve requirement is the required amount of depository liabilities as set by the Fed that a bank has to hold onto. It's usually a percentage. So the example I'll use is 10%. So the fact that banks can lend out a portion of customer deposits is what makes it possible for them to create money in our economy. And that's essential for understanding that in this tutorial on expanding or contracting the money supply. So we'll be talking about that later on.

But it's the money multiplier that actually calculates the amount that the money supply can increase through this ability to loan funds out. So the money multiplier is the increase in the money supply resulting from the ability of banks to loan deposits. It's going to be equal to 1 divided by r, where r is the reserve ratio.

So with the example of a 10% reserve requirement, you can see that the multiplier then becomes 10, because 1 divided by the 10% equals 10. So you can see that if we take a $1,000 initial loan or an amount in m0 which is the physical cash in our economy, that can lead to a potential, if we multiply it by 10, $10,000 increase in m1

So you can see very easily that as we raise and lower the reserve requirement, it either makes the multiplier bigger or smaller. If we would lower the reserve requirement, that makes the multiplied effect, or the impact that banks could have the money supply through their loaning, much greater. If we would raise the reserve requirement, it would make this ability smaller because the multiplier would be smaller.

Open market operations are another tool. So this is one of the mechanisms available to the Fed to regulate interest rates and the money supply. But here we're referring to the purchase and sale of US Treasury securities. We'll talk about those.

Next we have the Fed funds target rate, which is when banks need to borrow money because, let's say they haven't met the reserve requirement for the night, they can actually borrow from one another. And this Fed funds target rate, this is the rate that they would pay to borrow from one another. If they need to borrow from the Fed itself, they can to meet their short-term liquidity needs. They would pay the discount, or window rate, to the Fed itself.

So what does the Fed do when we're in a recession? Well let's talk about what's happening during a recession. Economic activity is slowing as measured by real GDP. And often consumers and businesses just aren't spending as much money because they're not very confident in the economy. So if I'm not confident, maybe I say things like, oh, jeez. Maybe I should put off my summer vacation this year. What if I lose my job? I'll save the money instead. Likewise, let's just eat in this weekend instead of our usual restaurant meal out. We'll save that money.

So how does that impact the money supply? Well when I decide not to go out to eat this weekend, it doesn't just impact me, that reduces the amount of money the restaurant is making. They then have less money to pay their workers. Those workers are then less likely to make purchases somewhere else.

And you can see that this has a multiplied effect in the economy. And it's a multiplied negative impact in the economy. So it shows that when consumers and businesses are not spending as much money or as frequently, it can reduce the size of m1.

Now there's a risk for deflation since people are tending to hold onto money and save it, keeping it in the banks. So to help reduce this risk and get people spending money again, the Fed can enact expansionary monetary policy. And what they do is increase the money supply. It's also known as easy money policy.

So expansionary policy is either monetary or fiscal policy, here we're focusing on monetary, that is enacted to stimulate economic growth. So it aims to get the economy moving again. And it achieves this by enticing people to take money out of the banks and spend it.

Here are the things they can do. They can lower the reserve requirement. You saw with that multiplier that as they lower the reserve requirement, it allows banks to make more loans. It gets money circulating out there instead of staying in the banks.

The Fed can also buy Treasury securities. When someone buys something from you, you walk away with money, right? So when they buy Treasury securities off of bondholders, bondholders have money. It's therefore injected basically into the economy.

They can also take measures to lower rates, like the discount rate, and they can target that Fed funds rate. Then loaning is easier. It's cheaper. And money leaves the banks inside of staying in so much. So they all work kind of the same way but through slightly different tools.

This is what it looks like when the Fed enacts easy money policy. When they increase the money supply, it's going to lower interest rates throughout the economy. And remember, at lower rates, people and firms tend to take money out and take advantage of the lower rates by taking out loans for things like homes and cars. This is what has an expansionary effect on the economy then.

Another way to think about this is when the Fed increases the money supply, essentially they're creating a little inflation. And that might sound bad, but the idea is since we're basically making purchasing power of money decrease, people will want to spend the money sooner rather than later rather than continuing to hold onto it with a little bit of inflation. And during a recession, a little inflation isn't a bad thing because generally inflation is very low during a recession.

So again here we're trying to encourage people to spend, spend, spend. That's the idea with expansionary policy. So in current times during the housing crisis of 2007 to 2008, our Fed took a lot of measures to ensure that banks would not fail and could continue to make loans.

First of all, they purchased billions of dollars of Treasury and other securities. And this is called credit easing. They drove the discount rate way down, the lowest I can ever remember it being in history, essentially allowing member banks to borrow money from them for free.

Now let's talk about the opposite situation when there's inflation in the economy. During a really rapid expansionary period, economic activity is growing. Consumers and businesses are spending a lot of money and very quickly due to high confidence and prosperous economic times. It sounds good, right?

I will definitely go on a summer vacation this year. Things are great in the economy. Let's go out to dinner instead of eating in this weekend. Now people are making these kinds of decisions, which are all good. When I decide to go out this weekend, that's increasing the amount of money the restaurant is making. They pay their workers. Those workers then can make purchases elsewhere. This has a multiplied positive effect in the economy. Again all good.

However, this shows that when consumers and businesses are spending a lot of money, it increases the size of M1. And now there is a risk for inflation. So people aren't holding onto money, and it's changing hands very quickly.

A little inflation is fine. But it is possible for the economy get overheated. So sometimes when that risk is high, the Fed will step in and enact contractionary monetary policy to try to slow down an overheated economy.

Here they're going to do all the opposite things and decrease the money supply. This is known as tight money policy. So a contractionary policy, here again, we're focusing on the monetary side of it, is policy that's enacted to slow economic growth.

We are trying to slow down the economy. And it can achieve this by trying to entice people to keep money in the banks. Again, the opposite of what we've already been talking about. Spend less money.

So they can raise the reserve requirements, sell Treasury securities taking money out of people's hands, and take measures to raise rates. When we enact tight money policy, that decreases the money supply and raises interest rates in the economy. People and firms now tend to keep money in the banks and take out fewer loans. This has a contractionary or slowing effect on the economy.

In the late 1970s and early '80s, our economy had significantly double-digit inflation. The Fed sold securities. They raised rates in an attempt to contract the money supply and slow down the rate of inflation, just like we've been talking about.

So this tutorial, here are all the things that we talked about, what the Fed's goals are, what they do during a recession, what they do during a time where inflation is a major risk. And we talked about how these policies really work by either encouraging people to take out loans and spend money or to keep money in the banks and slow things down.

Thanks so much for listening. Have a great day.

Notes on "Expansionary/Contractionary Policy and the Multiplier Effect"

Terms to Know

Money Multiplier

The increase in the money supply resulting from the ability of banks to loan deposits; the value is equal to the reciprocal of the prevailing reserve ratio or 1/R, where R is the reserve ratio.

Reserves

A portion of deposits required to be held by a bank; reserves usually are kept to maintain reserve requirements, as set by the Fed.

Reserve Requirement

The required amount of depository liabilities as set by the Fed that a bank must hold, typically quoted as a percentage.

Fed Funds Target Rate

The rate that Fed member banks charge other member banks for overnight loans—typically made to meet reserve requirements.

Open-Market Operations

One of the mechanisms available to the Fed to regulate interest rates and the money supply; open market operation refer to the purchase and sale of U.S. Treasury securities.

Discount (window) Rate

The rate the Fed charges member banks for short-term loans to meet temporary liquidity needs.

Expansionary Policy

Either monetary or fiscal policy that is enacted to stimulate economic growth (as measured by the GDP growth rate).

Contractionary Policy

Either monetary or fiscal policy that is enacted to slow economic growth (as measured by the GDP growth rate).

Monetary Policy

Typically policy set by a central banking authority, whereby money supply access and the resulting cost or access to money (interest rate) is varied to assist in stabilizing economic activity.