Question

1. Consider our most recent recession. Suggest an appropriate monetary policy intervention to remedy the situation. Explain how the Fed will carry out this intervention (suggest a specific tool and how it can be used), and what the actions of the banking system will (may) e after the Fed's intervention. How will this affect the AD, what will be the effects on inflation and unemployment.

Answer 1

The common feature among most countries in the recent recession has been that there has been a drastic decline in aggregate demand. There have been disruptions to aggregate supply as well, but most of these have been corrected after the lockdown measures were lifted.

However, low demand is still a problem.

a) Most countries have resorted to expansionary monetary policy to resolve this situation. This is where the central bank eases the flow of money in the system, and attempts to make liquidity more easily available.

b) Specific tools are: open market purchases, reduction in discount rate, and reduction in reserve requirements.

The Fed uses (and has used) all of these tools, after the recession.

A change in the discount rate affects all other interest rates. It reduces the rate at which banks borrow from the Fed.

Open market purchases increase the liquidity available with banks. The Fed purchases bonds from banks, and in return provides them with cash.

A reduction in reserve requirements means that banks can lend out more loans. They have to maintain less reserves.

With the Fed's intervention, banks are also expected to pass on the benefits to households and firms.

c) This expansionary monetary policy will shift the AD curve to the right, while AS curve will not shift in the short run.

This will lead to an increase in the real GDP level.

The price level will rise (inflation will rise).

Unemployment levels will fall.

Consumption expenditure and Investment expenditure will rise.