Question

1. Suppose Country A is suffering from recession. The policy makers could increase the government spending to raise the output to end the recession. But such a policy could also cause a negative side effect on AD and therefore reduces the policy effectiveness. Explain.
2. Except raising government spending, adjusting interest rate might be an alternative. Recommend such an alternative policy to the government that is also suitable for the current situation of Country A. Illustrate one method that the government can use to change the interest rate, and to explain the way to which it helps to end the recession.

Answer 1

a. The government policies to end a recessionary output gap are expansionary fiscal and monetary policy. But the expansionary fiscal policy creates a negative effect on aggregate demand by reducing private investment. Such effect is known as the crowding out effect of public expenditure. When the government undertakes an expansionary fiscal policy, it borrows from the public. The increased borrowing by the government to finance the public expenditure raises the rate of interest. The increased rate of interest reduces the private sector investment. Thus the effectiveness of an expansionary fiscal policy is reduced to a large extend by the crowding out. Thus it is not sure that an expansionary fiscal policy is an effective way to end a recession.

b. A recessionary gap is also can end up with change in rate of interest. The central monetary authority can follow an expansionary monetary policy for this end. The central bank uses open market purchase of securities, reduce the discount rate and reserve ratio and reduce the interest on reserves. Such policies increase the credit creating capacity of commercial banks. As more money is flawed into the economy with lower interest rate the consumption and investment expenditure increase. The increase in aggregate demand will raise the national output to an extent to fill an output gap created by a recession.

The most common and widely used method to adjust the rate of interest is the open market purchase of securities. During recession the central banks purchase securities from the public. This will pump more money into the economy and the reserves of commercial banks increase. This will induce the commercial banks to expand credit. The availability of more credit at lower interest rate creates more consumption demand and investment demand. This increase in aggregate demand rise the price level which will further increase aggregate output and finally the recessionary gap is end up.