How the Federal Reserve uses expansionary monetary policy to stimulate growth during an economic downturn

• Expansionary monetary policy is a tool central banks use to stimulate a declining economy and GDP.
• The Federal Reserve has three expansionary monetary policy methods: lowering interest rates, decreasing banks' reserve requirements, and buying government securities.
• Expansionary monetary policy's aim is to make it easier for individuals and companies to borrow and spend money — actions that all stimulate the economy.

Modern, capitalist economies go through regular fluctuations of growth, contraction, and eventual recovery. This repeating nature of the economy is known as a business cycle.

During the contractionary phase, gross domestic product (GDP) is decreasing, which can lead to a prolonged period of economic decline. To combat the slowdown, a nation's central bank will stimulate growth through an expansionary monetary policy.

What is expansionary monetary policy?

Expansionary monetary policy is a macroeconomic tool that a central bank — like the Federal Reserve in the US — uses to stimulate economic growth within a nation. A bank usually implements it during a contractionary phase of the business cycle — when the gross domestic product (GDP) in a nation starts to decline.

A decline in GDP can have a variety of undesirable effects, including:

• Business bankruptcies/failures
• Unemployment
• A fall in the stock market
• A decline in the national currency's value

All these effects, if unchecked, can eventually lead to a recession or depression.

The overall goal of any expansionary policy is to encourage spending and borrowing. The theory: More money available to individuals and businesses at lower cost will result in the increased purchase of goods and services, stimulating growth.

When the economy is growing too fast and inflation is rising quicker than desired, a central bank will do the opposite: seek to slow down the economy through a contractionary monetary policy.

Expansionary monetary policy tools

The Federal Reserve's expansionary monetary policy often takes a three-pronged approach:

• Lowering interest rates
• Reducing the reserve requirement (the amount of cash banks must keep on hand)
• Buying back government securities

Lowering interest rates

To increase the money supply — that is, the amount of cash and easily obtainable funds circulating throughout the country — the Federal Reserve reduces short-term interest rates. It can do so in two ways: reducing the federal funds rate and the discount rate.

• The federal funds rate is the interest rate banks charge each other for extremely short-term loans. The Fed requires that banks keep a certain percentage of their deposits on hand every night to maintain a certain level of solvency. If banks are short on deposits to meet the requirement, they borrow from another, often overnight, at a rate the Fed sets. When the Fed lowers the rate, it becomes cheaper for banks to borrow money, leaving them with more funds to lend out to customers. Banks then also lower the rate they charge customers on loans.
• The discount rate, which is higher than the fed funds rate, is the interest Federal Reserve charges financial institutions to borrow directly from one of its 12 branch banks. A bank goes to the Fed directly if it can't borrow from another bank. Reducing this rate also frees up a bank to loan more money, at less interest, to clients. The Fed can also try to help by extending the discount rate on loans not just overnight but for several months.

In both cases, as a result of cheaper, easier loans, customers now also have more money on hand to spend, which they can use to purchase more goods and services, stimulating the economy. Businesses, too, are encouraged to borrow, using the funds to expand operations.

Reducing the reserve requirement

Along with having to have a certain amount of deposits on hand every night, the Fed requires banks to hold a certain amount of cash at all times — money that must never be lent out. This "reserve requirement" is to ensure that banks can always give depositors their money if they need it, and handle sudden large withdrawals — preventing a disastrous "run on the bank."

The Fed constantly monitors the sums the banks must keep in reserve. If it wants to encourage lending and spending, it can reduce the reserve requirement, which frees up funds for the bank. This extra money can then be lent out to customers, increasing the overall money supply.

Buying back government securities

As part of an expansionary monetary policy, the Fed will buy government securities — that is, US Treasury bonds, bills, and notes. The Fed prints money to buy these securities from banks and other financial institutions.

Officially known as open market operations, this process adds more cash into banks, giving them more money to loan to individuals and businesses.

Expansionary vs. contractionary monetary policy

Contractionary monetary policy is the opposite of expansionary monetary policy. Contractionary policies are implemented during the expansionary phase of a business cycle to slow down economic growth.

Slowing down growth sounds counterintuitive. However, growth that is too fast can lead to dangerous inflation — prices rising too high, too fast.

Inflation occurs naturally in an economy, and the US targets an annual inflation rate of 2%. Once inflation starts to go above 2%, meaning costs for goods and services are increasing faster than the desired rate, the government and central bank put on the brakes.

In a contractionary monetary policy, the Fed uses the same tools as it does for expansion, but they're reversed. The central bank increases interest rates, increases the reserve requirement, and sells government securities (decreasing open market operations).

A real-life example of expansionary monetary policy

The Great Recession of 2007-2009 is a prime example of an expansionary monetary policy used to curb an economy in free fall.

For most of 2007, the fed funds rate was fairly stable at 5.25%. When troubling signs in the housing market first started to appear, the Fed reduced the rate to 4.75% in September 2007. Once the housing market collapsed, and the recession began in December 2007, the rate decreased to 4.25%.

The Fed also lessened the gap between the discount rate and the fed funds rate, and extended the period for discount-rate loans.

The Fed continued to drop the rate for a year, up until December 2008 when the fed funds rate hit 0%. But, because the recession was so severe, the decrease in the fed funds rate and the discount rate to zero was not enough to combat it.

The Federal Reserve then entered into quantitative easing, which is an irregular method of open market operations. Quantitative easing is implemented when the Fed funds rate cannot be lowered any further.

It bought longer-term government securities than it usually would — 20- and 30-year bonds. In addition, it also expanded the types of securities it could buy, such as mortgage-backed securities (MBS).

The Fed's quantitative easing is considered to be one of the main reasons why the Great Recession lasted only two years, and the economy recovered, albeit slowly.

The Fed's balance sheet increased from $882 billion in December 2007 to $4.5 trillion in May 2017. As a percent of GDP, this was an increase from 6% to 24%.

As for the fed funds rate, it stayed at 0% until 2015, at which time the Fed raised the rate to 0.5%.

The financial takeaway

When GDP in a nation is declining and the economy is in a contractionary phase, a nation's central bank will implement an expansionary monetary policy.

The policy can be achieved in several different ways, including a lowering of interest rates, a lowering of the reserve requirement, and an increase in purchases of government securities.

All of these actions will increase the money supply in an economy, meaning that individuals and businesses can obtain loans at a lower cost, encouraging them to spend that additional money.

When consumers and companies buy more, it increases demand, which results in businesses needing to produce more to meet the increased demand, requiring them to spend more money and hire more workers, reducing unemployment.

And hopefully, it all reverses the downward trend — creating a cycle of growth.

Related Coverage in Investing:

What is a recession? How economists define periods of economic downturn

Why double-dip recessions are especially difficult, and what they mean for the general state of the economy

When the Fed cuts interest rates, it affects everything from your savings account to your auto loans

What is a bear market? How to make sense of a prolonged period of decline in the stock market and invest wisely

A bull market means that stocks are rising, but it pays to understand how it works before you charge