Question

Suppose the Macroeconomy is in a state of severe recession as a result of significant declines in aggregate demand. When you were asked to advise the Chairperson of the Federal Reserve about possible policy choices to deal with the this problem, you decided to recommend the use of monetary policy. To convince the Chairperson and the members of the FOMC that monetary policy works, will you recommend either an expansionary or a contractionary monetary policy?Explain your analysis and its results using the AD and AS supply diagrams to illustrate your answers and conclusions regarding how the recessionary gap is eliminated. State what you believe will happen to the key Macroeconomic Variables. [Note: You must use the transmission mechanism process and graphs to diagrammatically illustrate your answers. No credit will be earned without the proper use of these diagrams].

Answer 1

During recession, the objective is to boost aggregate demand which can be achieved using expansionary monetary policy, by increasing money supply. Higher money supply lowers interest rate which incraeses investment demand and the portion of consumption demand funded by borrowing. Aggregate demand rises, increasing real GDP, price level, income and output. Unemployment rate falls.

In following graph, long run equilibrium is at point A where aggregate demand (AD0), short-run aggregate supply curve (SRAS0) and long-run aggregate supply curve (LRAS0) intersect with initial price level P0 and real GDP (potential GDP) Y0. During recession, real GDP is lower than potential GDP and the economy is at point B where a lower aggregate demand curve AD1 intersects SRAS0 with lower price level P1 and lower real GDP Y1, creating a recessionary gap equal to (Y0 - Y1). As a result of expansionary monetary policy, aggregate demand will increase and AD1 will shift rightward until equilibrium is restored at point A with price P0 and real GDP Y0.