Q: Evaluate the effectiveness of monetary policy to increase aggregate demand during a recession.(15m)

ANS:

Monetary policy refers to the manipulation of monetary variables such as interest rates to influence the level of economic activity. During a recession, economic growth will have reduced, and the central bank may implement an expansionary monetary policy to increase the level of AD. The effectiveness of monetary policy in doing so will be discussed below.

With a lower cost of borrowing, consumers and firms may borrow more from commercial banks, since it is now cheaper to borrow. As consumers borrow more, they will likely spend more on goods and services, raising consumption spending. Firms will spend more on capital goods, as they buy more machineries to increase their productive capacity. Investment spending increases. Assuming that the economy was initially facing a recessionary gap, with actual output level less than the potential output level, the rightward shift of AD curve may now return the economy to the long-run equilibrium level.

AD curve shifts right from AD0 to AD1, causing GPL and real GDP to increase. Real GDP is now at Y1, the potential output level; resources are used efficiently to produce output and the recessionary gap is then closed.

Monetary policy may be implemented relatively fast, as the central banks will need to determine the extent of decrease and announce the change. This may then lead to an increase in consumption and investment spending rather quickly later on, thus closing the output gap.

However, monetary policies may not be fully effective at closing recessionary gaps.

During periods of recession, consumers and firms may feel more pessimistic towards the state of economy, and feel uncertain that their income levels may rise. As such, they may not be willing to borrow more from the commercial banks despite the fall in interest rates. This leads to a less than proportionate increase in borrowing of money with a fall in interest rates; AD may not increase sufficiently to address the recession fully.

In addition, with the increase in AD, demand-pull inflation also occurs. As seen from the diagram above, GPL increases from PL0 to PL1 with the rightward shift of AD curve. As such, the government’s aims of achieving a low and stable inflation may be compromised, since goods and services are on average more expensive now.

However, given that the economy is in a recession now, with low levels of GPL, even with AD increasing, the GPL is unlikely to rise to extremely high levels. This implies that demand-pull inflation is unlikely a concern for the economy.

In conclusion, the benefits of monetary policy are likely to outweigh the costs, making the policy a largely effective one. As mentioned above, the costs of monetary policy may not be a valid concern, such as the possibility of high inflation rates, since GPL is at a lower level now. In the short term, monetary policy may address a recession more fully, but to deal with the problem, other policies may also need to be implemented.

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