Question

a) describe the concept of a recessionary gap and whether expansionary or contractionary policy has to be employed to return the economy to a healthy state

b) discuss the tools available to the Federal and specially what action would be taken with each. e.g, open market sale or purchase

c) Construct a sequence that would unfold based on the course of actions taken above, i.e, the impact on the money supply, interest rates, consumer and investment spending, aggregate demand and GDP

d) discuss the impact these actions would eventually have on the inflation and unemployment rates

Answer 1

Part A)

A recessionary gap is one, wherein the demand for goods and services is low in the economy and the resultant is that the producers make significant losses and to repair the same, they often need to fire people so as to curtail the cost of operations.

The situation becomes such, that low income leads to lower demand for goods and services and lower demand then translates into producers not making sufficient profits for themselves. The flow of money during a typical recession is low and the investment and aggregate or total demand in the country is also very weak.

During this time period, an expansionary policy is required to bring back the economy to its normal state. This is one in which the government or the central bank reduces the interest rates and takes numerous actions as explained in the following sections such as tax breaks so as to allow the money in circulation to expand.

Part B)

The federal reserve has 3 major tools which it uses to correct the economy. These are named and explained as follows: -

1) The Cash Reserve Ratio is the minimum amount of money which commercial banks must keep with the Federal Reserve at all times. The Federal Reserve during a recession, reduces the same, so that the availability of funds with the commercial banks can increase many folds. The end result is that the lending capacity of the banks increases and cheaper loans are available at large to the market place which helps in increasing the aggregate demand from the consumers point of view and the chances of expansion for the producer as well.

2) Lower Interest Rates is the second strategy which is used by the Federal Reserve as a measure to ensure that the economy can stay stable during times of a recession. This acts as an added advantage to consume more and to produce more as loans are available at a cheaper rate. Further, savings do not give people the same kind of returns that they earlier used to and as a result people do not prefer saving but spend and increase their demand and this further helps producers in expanding as well.

3) Now, the last thing to keep in mind are Open Market Operations, wherein, the Federal Reserve, purchases bonds in the open market. When bonds are purchased, the federal reserve supplies the market with additional cash and takes away the bonds which then it holds. This provides funds to those that hold bonds which are usually financial institutions and can be used for expansion.

Part C)

Once, an expansion strategy is applied to the economy, the interest rates go down significantly. This results in the aggregate demand for goods and services to become higher, as loans are then available at a much lower rate than they earlier used to and savings do not provide equal returns for investors.

As loans are available at lucrative rates, consumers increase their spending and even those that have earlier saved their money in banks, and do not see returns either invest the same in companies through shares or mutual funds to gain higher returns or spend in a market wherein the cost of loans is considerably low. As demand for goods and services increases, the investment capability for business owners also increases.

The aggregate demand refers to the total demand for goods and services, which as described rises in value and as this happens, the value of final goods produced in the country which account for the GDP or gross domestic product of the country also rise.

Part D)

The impact of these actions on the inflation rate would be positive. The economy prior to these actions was in a state of negative inflation which may become stable or even translate to positive inflation which to a certain extent is acceptable in a developing or developed society. For example, for the United States a target inflation rate of 2% is acceptable.

As demand in the economy grows, the unemployment in the country goes down as producers expect to expand their operations.

Please feel free to ask your doubts in the comments section.