Question

Question 4

4.1 List and discuss any two (2) tools of monetary policy                                                  (10)

4.2 Explain how a government can use fiscal policy to combat a recession in a economy (10)

Answer 1

4.1

1. Open market operations: The central bank can increase or decrease money supply by performing open market operations. The central bank buys/sells government securities from commercial banks which has a direct effect on the economy's money supply as it changes the reserve amounts with banks. Money supply is a driving factor of a change in interest rate.

2. Reserve requirement: The central bank can increase/decrease reserve requirement (LRR,SLR) to increase/decrease money supply. The reserve requirement is the percentage of deposits banks are required to keep with themselves and with the central bank at any given time. After a decrease in reserve requirements, banks would have more reserves which would lead to more lending and an increase in money supply.

4.2 A recession is a state where the aggregate demand curve shifts to the left which leads to a decrease in the economy's short run output. In order to bring the economy back to its full employment output level, the government can use expansionary fiscal policy to induce consumption and investment spending. One such way of performing this activity is by decreasing tax rates. After a decrease in tax rates, disposable income rises which leads to an increase in consumption expenditure. Another method is an increase in government spending. An increase in government spending is expenditure on bridges, roads, healthcare, etc by the government. After this increase in government expenditure, consumption expenditure rises which shifts the aggregate demand curve to the right and the output back at the full employment level.