How would a policy of monetary expansion effect the domestic economy in the short term?

To answer this question we firstly need to remind ourselves of the core components of Aggregate Demand (AD):

AD = C + I + G + (X-M)

AD is made up of Consumption, Investment, Government Spending and the net effect of Exports – Imports.

A policy of monetary expansion could be pursued through a reduction in the Bank of England’s base rate – this is the rate to which the bank is lending money to the rest of the economy through intermediate banks. Lowering this bank rate increases the supply of money within the economy with expansionary effects to Aggregate Demand.

The effect of a monetary expansion is transmitted through two channels:

1) Increased Consumption and Investment

As the availability of credit is increased the cost of credit is reduced. With these positive changes to the cost and availability of credit the incentives to borrow money to invest and consume will increase. Simultaneously the incentives to save will reduce as savers are earning less from keeping their money in savings accounts. Generally speaking a pound not saved is a pound spent. Therefore a monetary expansion will have positive effects to both domestic consumption and investment shifting AD upwards.

2) An Increase in Exports (Improvement in the Balance of Payments)

As the gains from savings are reduced, the UK will prove a less attractive destination for foreign capital. This will reduce the flow of “hot money” into the UK and even send foreign capital out of the UK to other jurisdictions where the interest rate is higher. The result is a lower demand for Sterling causing a depreciation in the economies currency. After a depreciation in the UK’s currency, British exports will appear cheaper on international markets and will therefore increase in volume.  An increase in exports will, as a component of AD, result in a positive shift in Aggregate Demand.

Real world examples: We have seen this process occur in light of the Brexit vote where a depreciation in the currency has reduced the UK’s Balance of Payments deficit.

Depict graphically.