Question

1. The economy is in a recession. The government increases spending in an effort to move the economy toward full employment (Y*). Money demand is interest sensitive and investment interests insensitive.
   1. explain each step of the adjustment process,
   2. graph the process (show both “the crowing out” and the path –process– the economy will follow).
   3. How much crowding out would you expect relative to an economy wherein Money demand is interesting insensitive and investment is interest sensitive and why.

Answer 1

Status of Economy in Recession

When there is Negative GDP (Gross Domestic Product) growth for more than two or three consecutive quarters, it is considered a Recession Period. In simple terms, we can say economic growth slows down during recession. Some important attributes of an economy facing recession include decrease in sales and revenues, crash of stock prices, lower incomes and higher unemployment.

In the state of recession, an economy faces decrease in business sales and revenues, causing businesses to stop thriving. When there is no high demand, businesses bear losses and try to control their costs by reducing wages rate or stops hiring new workforce, it increases the unemployment rate. It results into a decrease in the GDP, and can cause some firms to go bankrupt, also resulting in massive layoffs that also increase unemployment.

(a) & (b) Recession effects worsen the situation. A diagramatic representation is given below for simple explanation of Recession adjustment process:-

(c) Money demand is interest insensitive and investment is interest sensitive, this can be controlled through wise decision of the Government. Government plays an important role in the time of recession through their monetary or fiscal policy and controls money supply. It takes various initiative like lowering interest rates, increasing government spending, and money supply of banks. A recession is a fall in real GDP which causes bad effect on the country. Government controls its economy through easing of monetary policy, spending through fiscal policy, and ensuring financial stability.