Expansionary monetary policy is an economic policy engineered by a country's central bank (like the U.S. Federal Reserve) designed to ratchet up a nation's economy, often in a time of economic peril.

While central banks may deploy various policies to boost an economy, the strategy that is often used is the lowering of a nation's interest rates, led by a central bank. This strategy is meant to produce two positive economic outcomes:

  • It increases the money supply, unleashing the power of free markets with access to more cash and at lower interest rates, to revitalize the economy.
  • It increases aggregate demand for capital, resulting in more money to engage in real-world economic activities, like consumers buying more homes and autos and businesses investing in more hiring and more spending on research, operations, and marketing and advertising.
  • It lowers a nation's currency value, thus curbing that nation's exchange rate, making it more affordable to do business in that country.

Central banks may engage in more alternative, even unorthodox strategies to expand an economy.

  • A central bank may opt to push an economy-growing policy like quantitative easing, which boosts the money supply by the buy-up of government bonds, which curbs interest rates. The U.S. Federal Reserve opted for this approach in the immediate aftermath of the Great Recession.
  • Or, a central bank may go full throttle and steer money directly to a nation's businesses and individuals to boost spending. This is a strategy more likely to be adopted by developing nations, which have limited economic resources, and cannot engage on broader expansionary policies, like buying billions worth of government bonds.

The Great Recession and Expansionary Economic Policy

A good example of a country kick-starting an expansionary monetary policy is the 2008-2009 Great Recession, which impacted countries around the world, including the U.S. and the U.K.

In both of those countries, central banks cut interest rates to near 0% levels after the recession hit, with the intent of expanding the pool of low-cost capital so individuals and businesses had easier access to cheaper money.

The idea was to lower rates to the point where consumers would borrow more freely and inject more money into moribund country economies. In the case of the Bank of England, interest rates were cut significantly from 5% to 0.5% within several months during 2008 and 2009.

Likewise, the U.S. Federal Reserve adopted the same tactic, slashing rates to an eventual effective interest rate of 0%, giving borrowers a significant incentive to borrow money, use their credit more robustly, and spread money throughout the economy.

Both central banks also kept a sharp eye on inflation which tends to rise in a low-interest rate environment. Yet economists adopted a low-interest rate policy just the same, figuring it an acceptable risk at a period when economic growth trumped other potential economic outcomes.

One negative outcome from expansionary economic policies during tough economic times is that the policy discourages savings.

With interest rates low on savings-oriented investment vehicles like bank savings and checking accounts, money market accounts, certificates of deposit, and government and corporate bonds, savers had to look elsewhere to generate wealth, and wound up investing more money in capital appreciation vehicles, like stocks and commodities.

At the same time, the Bank of England and the U.S. Federal Reserve engaged in quantitative easing - essentially creating money and steering that money toward the acquisition of government bonds from private banks.

That strategy was designed to boost national money supplies and continue to aid the policy of lowering interest rates, which would result in more bank lending to consumers and businesses. The strategy was also designed to lower bank interest rates, resulting in more borrowing of capital among the populace and stronger spending on capital and investments.

There was no guarantee the policy would work. Economic conditions back in 2008 and 2009 were so dire that consumers weren't exactly gung-ho about spending money, even if credit was cheap and money (in the form of lower-rate loans) widely available.

Additionally, while banks were the primary beneficiaries of quantitative easing policies, they weren't forced to pass on lower-interest loans to the general population. Indeed, many didn't, causing economic growth to slow down severely.

The result of expansionary economic policies during and after the Great Recession?

While economists differ, a general consensus developed that while expansionary economic policies didn't trigger an outright economic boom, it did just enough to help economies in the U.S. and the U.K. generate some much-needed traction and kept economies in both countries on a path to recovery, albeit at a glacial pace.

Contractionary Economic Policy

Most economic environments aren't as dire as they were in the Great Recession, but it's also safe to say that central banks are always looking for ways to either stimulate economic growth or sustain it once an economy is rolling.

Sometimes, that blueprint works too well, as economies grow too hot and accelerate too fast, which may well cause a central bank act to slow that growth down. Central banks can trigger too much economic growth by injecting too much money into a nation's economy, which usually results in inflation.

In a word, inflation means a rise in the price of goods and services, which leads to a rising cost of living as prices climb throughout a nation's economy.

Inflation is measured by the national inflation rate, i.e., the regular percentage change in economic prices as measured by economic benchmarks like the Consumer Price Index (CPI) in the U.S. and the Retail Price Index (RPI) in the U.K.

In general, a central bank like the Federal Reserve aims for a "sweet spot" on inflation, usually at a rate of 2%. Anything above that means the economy could be growing too fast, and that prices are growing too high, leading a central bank to shift to a contractionary or restrictive economic policy.

In that scenario, a central bank will usually opt to boost interest rates and sell some of its government bond holdings to curb economic growth. It does by reducing a nation's money supply, hardening lending and credit conditions, and keeping a nation's inflation rate around that preferable 2% level.

That was the case in 2017 and 2018, when the U.S. Federal Reserve boosted interest rates three times in the former year and four times in the latter one. The Fed also sold a significant share of its government bond holdings to engineer what it hoped would be a "soft landing" in getting inflation to 2%, while keeping the U.S. economy on a steady growth path.

As for hitting that 2% inflation target through a decade of economic turmoil, the data shows the Federal Reserve did its job.

In the summer of 2008, right before the economic downturn, the U.S. economy was still in white-hot growth mode, with inflation at 5.6%. Over a decade later, in the first quarter of 2019, inflation, after numerous gyrations, stood at 1.9% - a level that apparently allows a central banker to sleep well at night.

How Is Expansionary Monetary Policy Helpful?

While central banks have to be careful in implementing expansionary economic policies (and in contractionary cycles, too), having the tools on hand to better grow and manage economic growth is a big positive for national economies.

Such policies don't usually work perfectly, but they do work often enough to keep expansionary monetary policies up front and center during crunch time.

That's when a steady hand at the economic wheel is no luxury - it's a necessity.

It's never too late - or too early - to plan and invest for the retirement you deserve. Get more information and a free trial subscription toTheStreet's Retirement Dailyto learn more about saving for and living in retirement. Got questions about money, retirement and/or investments? We've got answers.