Question

Provide arguments for and against fighting recession with expansionary monetary policy. First, explain the meaning of the terms recession and expansionary monetary policy. Use the models of money demand and money supply, aggregate demand and aggregate supply to illustrate your answer. Discuss monetary policy tools. (Ch 11 notes).

Answer 1

Recessionary monetary policy are adopted by Fed to reduce the money supply in the economy and raise rate of interest while expansionary monetary policy raise the money supply in the economy and reduce the rate of interest.

During recession, there occurs a recessionary gap in the economy where potential output is more than actual output in the economy. Fed use expansionary monetary policy to fight recession in the economy because by raising money supply they give more money in the hands of public thereby raising their willingness to pay for goods which in turn raise the aggregate demand in the economy. Raising aggregate demand from its current output level will take the economy to its potential level.

Rise in money supply will shift LM curve to its right while keeping IS as it is. It reduces the rate of interest from "i" to "i1" while raising output level.