Question

Q4 Suppose the economy is experiencing a recession and high unemployment. How would a monetary policy address this problem? Be sure to explain clearly the effects on excess reserves, money supply, interest rate and real GDP. You may use diagrams to illustrate your answer better. (10 points)

Answer 1

Initial equilibrium occurs at point E where Output level is Y1 and the price level is P1. However, the potential output is Yp. Since, Y1 < Yp, economy experiences a recessionary gap equivalent to the distance between Y1 and Yp.

Central Bank can use Expansionary Monetary Policy to close this gap. This policy will increase the flow of money supply into the economy. The excess reserves of the commercial banks will go up which would increase their lending capacity. Commercial banks would able to give more loans to the borrowers. Borrowers' income will increase and they will start spending more on goods and services.

As a result, the aggregate demand will increase and the AD curve shifts to right from AD to AD1. There will be upward movement on SRAS curve and the economy reaches to point E1. At this equilibrium, the recessionary gap is closed and economy reaches at potential output.

Money Supply increases.

Excess Reserves increase

Real GDP increase

Interest rate reduces.

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