Suppose an economy that starts in general equilibrium is thrown into a recession via a leftward...

Suppose an economy that starts in general equilibrium is thrown into a recession via a leftward shift in the IS curve. What type of monetary policy (expansionary or contractionary) could be beneficial in helping this economy return to general equilibrium? Why is such a policy beneficial? Are there consequences, risks or difficulties associated with implementing this policy? Discuss.

Expert Solution

If an economy is thrown into a recessiond ue to leftward shift in IS curve. Fed should adopt expansionary monetary policy such that they raise money supply in the economy. Due to rise in money supply, LM curve will shift to its right causing rate of interest to fall. A reduction in rate of interest will raise investment in the economy.

Rise in money supply will raise circulation of money in the economy which will end up people holding more money in their pockets and raising their willingness to pay for goods. As willingness to pay for good rises, aggregate demand curve shifts to its right from demand to new demand curbing recessionary gap in the economy and shifting output level from Y0 to Y1.

Consequence of expansionary monetary policy is that is results in higher inflation rate in the economy.

Risk of expansionary monetary policy is the time lag between policy is implemented and results it shows in the economy. If there is case that aggregate demand rises automatically to reach its long run equilibrium and effect of monetary policy hits economy after that. It will results in higher inflation than expected.

Rahul Sunny answered 2 years ago

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