What it means
There are two levers held by two different sets of hands. Fiscal expansion belongs to the government and works through spending, tax cuts and transfer payments, while monetary expansion belongs to the central bank and works through interest rates, reserve requirements and asset purchases.
Fiscal expansion is direct. If the state builds a railway, contractors are paid, workers spend their wages, and the money circulates through the wider economy in successive rounds, which economists call the multiplier effect.
Monetary expansion is indirect and works through the price of borrowing. Lower rates make mortgages, car loans and business investment cheaper, which is meant to encourage spending, although it only works if households and firms are willing to borrow in the first place.
For a business, expansionary policy usually shows up as cheaper debt and stronger demand arriving at the same time. That combination is pleasant while it lasts, but it tends to be temporary, and companies that build a permanent cost base around it are badly exposed when policy turns.
The limits are real. Push demand beyond what the economy can supply and you get inflation rather than growth, and fiscal expansion funded by borrowing eventually has to be paid for through higher taxes, lower spending or the erosion of the currency.
Timing is the hardest part of all. Policy acts with a lag of many months, so the stimulus intended to cushion a recession often arrives just as the economy is already recovering under its own steam, which is why central banks and finance ministries are so frequently accused of doing too much too late.
In practice
Real-world examples.
Example
A central bank cuts its policy rate from 5% to 3%, and a homeowner with a $500,000 interest-only mortgage sees annual interest fall from $25,000 to $15,000. That frees $10,000 a year to spend elsewhere, which is exactly the behaviour the rate cut was designed to produce across millions of households.
Example
A government announces a temporary cut in sales tax, and a furniture retailer sees orders jump 15% in the following quarter. The board brings forward a warehouse expansion, then has to decide whether the extra demand reflects a genuine recovery or simply purchases pulled forward from next year.
Example
A central bank restarts asset purchases during a downturn, pushing down long term bond yields across the market. A utility uses the window to refinance $600,000,000 of debt maturing in three years at a materially lower coupon, locking in the benefit of the policy long after the policy ends.
Formula
Calculation
Simple spending multiplier = 1 / (1 - marginal propensity to consume)
Change in output = multiplier x change in government spending
If households spend 75 cents of every extra dollar they receive, the marginal propensity to consume is 0.75 and the simple multiplier is 1 / (1 - 0.75) = 4. An extra $50,000,000,000 of government spending would then raise national output by 4 x $50,000,000,000 = $200,000,000,000.
Real multipliers are much smaller, because part of every dollar leaks into savings, taxes and imports instead of circulating domestically. Using a more realistic multiplier of 1.4, the same $50,000,000,000 of spending raises output by 1.4 x $50,000,000,000 = $70,000,000,000, which still exceeds the money spent but by far less than the textbook figure suggests.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Marrow Lane Furniture, an invented mid-sized manufacturer, entered a recession with $8,000,000 of floating rate debt costing 6.5% and revenue of $30,000,000. The central bank in this fictional scenario cut rates to 3.5% and the government added a temporary rebate for households.
Both levers helped at once. Interest costs fell by 3 percentage points, worth $8,000,000 x 0.03 = $240,000 a year, while consumer demand lifted revenue by 18% to $35,400,000, and the management team hired 40 staff and signed a ten year lease on a second unit.
Two years later inflation forced the central bank to raise rates to 7%. Interest on the same $8,000,000 rose from $280,000 to $560,000 a year, demand fell back towards its old level, and the fictional company discovered it had treated a policy-driven boom as a permanent change in its market.
Watch out
Common mistakes.
- Assuming expansionary policy always produces growth, when pushing demand past the economy's capacity mainly produces inflation instead.
- Confusing fiscal and monetary expansion, which are run by different institutions using different tools with different time lags.
- Building a permanent cost base on temporarily cheap borrowing, which is how otherwise sound businesses get caught when rates normalise.
Questions
People also ask.
How quickly does expansionary policy work?
Monetary changes typically take twelve to eighteen months to feed through fully, while fiscal spending can act faster once approved but is much slower to legislate.
Is quantitative easing expansionary policy?
Yes, it is a monetary tool used when interest rates are already close to zero and the central bank still wants to add stimulus by buying assets.
What is the opposite?
Contractionary policy, meaning higher interest rates, reduced government spending or higher taxes, used to cool an overheating economy and bring inflation back down.
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