Effects of an expansionary monetary policy in an economy

An expansionary monetary policy is to do with an increase in money supply which tends to have the following effects on an economy:

Inflationary tendencies – an increase in money supply arising from an expansionary monetary policy such as a reduction in the bank rate and therefore an increase in the lending capacity of commercial banks, is likely to cause inflation, particularly where such an increase is inconsistent with the short run productive capacity.

Disincentive to investment – a fall in the relative value of a domestic currency discourages investment potential due to:

  • An increase in cost of inputs (increase in production costs) which reduces profits
  • A fall in purchasing power and effective demand which again reduces profits through the intermediary of a downward pressure on the overall business turnover.
  • Increase in cost of capital – an expansionary monetary policy tends to increase the level of interest rates whose extreme effects include the banking crisis manifestations such as the disproportionately large amount of non-performing loans ( or even bad debt port folio), statutory management, branch network closures and sometimes liquidation.

However, where the expansionary monetary policy arises during a situation of low economic activity (recession), the tendency would be a fall in interest rates and an increase in equilibrium level of national income. Similarly, a given level of inflation would be necessary for the management of unemployment levels (denoted by the Phillip’s curve.)

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