Question

The economy of a country  is suffering from recession, use the suitable economic policy to correct this situation. Explain briefly & Graph your answer using Ad & AS model.

Answer 1

Figure-1 in the enclosed document below illustrates the impact of a recessionary gap in the goods market of a country and the appropriate government policy intervention to eliminate the initial recessionary gap created in the market. The AD, SRAS, and LRAS represent the short-run aggregate demand curve, short-run aggregate supply curve, and long-run aggregate supply curve respectively. AD1, SRAS1, and LRAS1 denote the initial short-run demand and supply curves and long-run aggregate supply curve in the goods market. The initial equilibrium level of real output or income in the goods market and the domestic economy is denoted as Y*1 which is the desirable full-employment level of real output or income level of Y*2 which corresponds to the intersection of AD2, SRAS2, and LRAS2. The existing equilibrium price level in the goods and market is indicated as P*1. The recessionary gap in the economy and/or the goods market is indicated by the difference between Y*2 and Y*1 in figure-1. Now, to offset the existing or prevailing recessionary effects or impacts in the goods market or the domestic economy, the government can either implement an expansionary fiscal policy characterized by an increase in the government expenditure or spending to mobilize and restructure various infrastructural and developmental projects and initiatives to ensure potential economic recovery or stabilization by raising the real output or income and generate more employment opportunities, or expansionary monetary policy by increasing the overall money supply or lowering the interest rate in the money or loanable funds market by the Central Bank in the country. An expansionary monetary policy would also lead to a higher overall investment level by firms and companies in the economy due to lower interest rate or cost of financial borrowing thereby, increasing the aggregate investment expenditure in the economy. A relatively lower interest rate would also induce consumers and households to undertake more financial borrowing or loans to finance large-scale consumption expenditure or spending. An increase in money supply by the Central Bank would also entail higher aggregate consumption expenditure or spending by the consumers and households as now money holding by individual consumers and household units would increase which would consequently lead to higher spending or expenditure on various goods and services in the economy. Therefore, both the increase in aggregate expenditure level and overall consumption expenditure or spending due to expansionary monetary policy by the Central Bank would lead to an increase in the AD in the goods market or domestic economy. Furthermore, an expansionary fiscal policy or increase in the overall government expenditure or spending in the economy would also increase the AD in the goods market. This increase in AD in the goods market of the hypothetical country has been depicted by an upward or rightward shift of the AD curve from AD1 to AD2 in figure-1. Now, due to the remedial or corrective measures undertaken by the government to reduce or eliminate the recessionary impact in the goods marker or economy, the AD curve moves from AD1 to AD2 and intersects SRAS1 and LARAS1 to restore the desired full-employment equilibrium real output or income level of Y*2. Observe that the recessionary gap between Y*2 and Y*1 has been diminished as a result of an increase in AD and the equilibrium price level of goods and services in the goods market increases from the recessionary level of P*1 to post-recessionary level at P*2, exhibiting an inflationary effect in the goods market and the economy due to the corrective measures undertaken by the government to mitigate or control the recessionary impact.