Question

7. Consider an economy experiencing a decline in business confidence. Assume that the central bank uses the real interest rate as its policy instrument and its ultimate objective is to keep output at the full-employment level.

A. Use the IS-LM model to explain and illustrate the impact of this shock on the equilibrium output level.

B. What is the appropriate Central Bank response to this shock? Illustrate and explain how the central bank uses open market operations under these circumstances.

C. Suppose that the central bank faces “zero lower bound.” What does this term mean? Illustrate and explain the dilemma of the central bank.

D. What are the options available to the monetary and fiscal policy-makers that face zero lower bound? Explain and illustrate.

Answer 1

Introduction

When there is negative economic growth for two or more consective quarters it can be called economic decline. Economic decline for a short period is called recession. It is a period of decline in all the economic activities of a particular economic region. This reslts fall in output due to unemployment. If the economy continues this situation for more than a couple of months it can be called depression.

The primary effect of recession is that people will get less opportunity to make money. This affects growth of business. It mostly affects small business units and it makes them difficult to survive. This makes many of the companies unable to continue their business operations.  

Recession impacts on large business units too.  

Impact of IS - LM Model

This is a two dimensional macro economic tool. This shows the actual relationship between interest rates and asset market. Here IS stands for investment savings and LM stands for liquidity preference money supply. If it is a closed economy the equilibrium condition is the market situation under which goods produced and the demand for goods are equal. In a closed economy interest rate is determined by the equilibrium of supply and demand for money. When output increases the demand for money raises. At the point where the two curves intersect both eqilibrium conditions are satisfied.

When recession affects an economy very badly Central Bank takes immediate steps to bring back the economy stable by providing Open market Operation. It makes changes in the domestic money supply. It also intervenes directly into the foeign exchange market by buying or selling crrency.

The primary objective of Central Bank intervention is to stabilize fluctuations in the exchange rate. Otherwise international trade and making investment decisions will be difficult. Holding of foeign assets called foreign exchange reserves is another economic policy adopted by the Central Bank during difficult economic situations.  

Zero Lower Board

This is a macro economic problem when the short term nominal interest rate is zero. This is a situation under which the Central bank has only a limited capacity to stimulate economic growth. In such policies which have lower interest rates, investors will change their product offers and it is more likely for them to exist the market. The consequence of this situation is that relocation of resources from affected fund and the asset mangement industries in general.

Monetary and fiscal policy

A eonomic situation characterised by depression , low inflation and menetary policy which is unable to stiulate the economy is called liquidity trap. When monetary policy comes under zero lower bound fiscal policy helps to achieve macro stabilization. Fiscal policy is a key variable policy within a single currency area. It helps policy makers to meet regional economic problems.  

The liquidity trap is a sitation under which monetary policy always becomes ineffective. Policy makers influence nominal interest rates. Under such situation privater agents will be willing to accept any amount of money with the exisiting interest rate.  

Hence under a situation of deep liquidity trap fiscal policy is more effective. The governent can pay for new investment schemes, creating jobs directly, and encourage people to invest in business, for effective economic growth.