Question

Explain how a) fiscal and b) monetary policies can be used to remove a recessionary gap.

Answer 1

Recessionary gap exists in the economy the when actual equilibrium gdp is less than the full employment equilibrium gdp (potential gdp).

Algaebrically ,

Recessionary gap = Potential Gdp - Actual Gdp

Recessionary gap occurs when the actual aggregate demand in the economy is less than than full employment level of aggregate demand. Thus to eliminate the recessionary gap the aggregate demand needs to be increased to the level of full employment aggregate demand. There are two types of policies to increase the aggregate demand - fiscal policy and monetary policy.

a) Fiscal policies used for increasing the aggregate demand are -

Increase the government expenditure which will directly increase aggregate demand and thus close recessionary gap.

Decrease the taxes which in turn will increase the disposable income. Increase in disposable income will increase consumption expenditure which in turn will increase aggregate demand and thus close the recessionary gap.

b) Monetary policy.

Aggregate demand can be increased via increasing the money supply in the economy. Monetary policy tools to increase the money supply are -

(i) Open market purchase of government bonds and securities.

(ii) decrease the margin requirement on loans.

(iii) Decrease the reserve requirement.

(iv) decrease the discount rate.