Question

Assume that the economy has just suffered a recessionary gap due to a dramatic drop in consumer confidence as new of trade negotiations with China deteriorate.

Charting the decline the consumer purchases and business investment, the aggregate demand curve has shifted to the left by $700 billion dollars.

As a newly hired economist and assistant to the Chairman of the Federal Reserve Bank, you are tasked with the responsibility to present an action plan using the tools of monetary policy.

What is your plan to move the AD back to full employment?

Note: You may make create any information you feel you need to run specific calculations to bak your recommendation.

Answer 1

A recessionary gap is a situation when an economy is operating at a level below its full employment equilibrium. In such a situation, the GDP is below its level of full employment and this puts downward pressure on prices in the long run.

The monetary policy is in the hands of the Fed and it is used to bring about changes in the interest rates and money supply in the market. Since in the given situation, there is a fall in demand due to recession, the government would pump money in the economy by increasing money supply and lower the interest rates. These types of policies are called expansionary economic policies which are also known as easy money policies.

Different monetary policies that the Fed can adopt are:

1. Open Market Operations: This involves buying or selling of U.S government securities using open market operations. In the situation of a recession, to bring back the AD ti full employment, the Fed will buy U.S securities to pump in money in the economy.
2. The Required Reserve Ratio: This specifies the amount of reserve banks must hold and limits the amount that banks may lend out to the public. In the case of a recessionary gap, the fed would decrease the reserve ration thus, increasing the amount by which banks can expand the money supply.
3. Discount rate: Banks borrow from the Fed and pay an interest rate known as the discount rate. During recessionary gap,the discount rate shall be lowered by the Fed thus, banks will have more incentive to borrow, thus increasing the money supply in the system.

The above mentioned actions can be taken by the Fed to get AD back in its full employment position.