Question

Suppose that the European Union is now experiencing a recession. Its actual real GDP is €200 billion, and the estimate of its potential real GDP is €350 billion. The European actual unemployment rate is now 9.0%, while its estimated natural rate of unemployment is 4.5%. What open market operation would you suggest that the European Central Bank do? Explain how this open market operation would bring the European Union back to full employment.

Answer 1

The economy is in a recessioanry gap and to close the this gap a central bank has to introduce an expansionary monetary policy. The central bank has got various tools to implement an expansionary monetary policy and the tools are ,

• Discount rate .
• Open market operations
• Reserve ratio.

The open market operations are the purchasing and selling of government owned securities by the central bank to inflence the monetary base in the economy. In a recesisonary situation the central bank need to purchase the government securities to increase the money supply. When they do a open market purchase they are injecting more money into the economy. Therefore, the increase in the money supply decreases the nominal interest rate in the economy. The nominal interest rate is the cost of borrowing so a decrease in the nominal interest rate would induce both the consumption and investment activities in the economy. Since the consumption and the investment are the components of the aggregate demand , the aggregate demand will increase and AD curve shifts to the right. The increase in the aggregate demand helps the economy to recover from a recession.