Question

Discuss how monetary and fiscal policy are used in a recessionary situation.

Answer 1

Monetary policy controls the amount of money supply in the economy. Monetary policy can be either restrictive or accomodative and the central bank will decide on which depending in the current economic circumstances.

Thus in any recessionary situation, we want to increase the money supply, this will decrease the interest rates and increase investment and consumption. This will increase the aggregate demand inclose to the recession gap.There are three tools in the monetary policy and they are

• Reserve requirement : Fed can lower the reserve requirements, which means the bank can create more money.
• Discount rate : They can lower the discount rate. Which means they can loan out more money to banks.
• Open market operations : They can buy bonds. When the Fed buy bonds, it puts money in the system and increase the money supply.

Fiscal policy is government spending programs and they are used to exert influence over the economy by controlling revenue and spending.

There are two tools in the fiscal policy and they are :

• Government spending : we can increase the government spending which will shift the aggregate demand to the right.
• Taxation : we can lower the taxes. Lowering taxes will increase the consumer spending which will also shift the aggregate demand to the right.

Thus by using these policies, we can get out of a recessionary situation.

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