Chapter 17, Problem 1PS

Summary Introduction

To determine: The monetary and fiscal policies which may be prescribed for an economy dealing with deep recession.

Introduction: The manipulation of the money supply and its effect on the interest rate is called as the monetary policy. The increment in the money supply and the decrement in the short term interest rate are the result of the expansionary monetary policy. The expansionary monetary policy also encourages investment and the consumption demand.

The fiscal policy can be defined as the steps taken by the Federal government to control the state of the economy. These steps are taken in consideration of the two important components of the budget which are taxes and government spending.

Answer to Problem 1PS

In order to pursue an expansionary monetary policy the U.S. Federal Reserve will have to lower the reserve requirements.

Explanation of Solution

Given Information: The actions required to pursue expansionary monetary policy by using the monetary tool is to be found.

The characteristics of the deep recession is given as −

• Inflation rate and interest rate fall.
• Gross domestic product and production level fall.
• Employment level and level of real income fall.

The prescribed monetary and fiscal policies for an economy in deep recession are given as −

The monetary policies can be defined as the management of the money supply in the market and this management is done by the monetary authorities such as U.S. Federal Reserve. The aim of this policy is to control in macro-economic variables and the stimulation of the economic activities like production, consumption and investment levels.

The steps taken by the Federal Reserve as a part of overall monetary policy given below −

Print more dollars − The printing of more dollars will results in the more money supply in the market. This increased money supply will increase the demand for the investment and the consumption and the simulation of the economy.

Buying treasury bonds − The dealing with the treasury securities in the market by the Federal Reserve is called as open market operation. The government will have to buy the treasury securities from the market in order to increase money supply. With the help of this condition, the money in the hand of the public will also increase which will result in the increased demand of the consumption and investment.

Reducing the reserve requirements − The reduction in reserve requirements refers that the banks have more money to lend to the public and investors. This process will increase demand of the consumption and the investment which stimulate the economy.

Reduce the discount rate − The reduction in discount rate will make the loan cheaper and in this case investor and the public can borrow money from the bank which will result in the increase in consumption and the investment.

The fiscal policy can be defined as the steps taken by the Federal government to control the state of the economy. These steps are taken in consideration of the two important components of the budget which are taxes and government spending. The impact of the fiscal policy is more effective than the monetary policy. The political and legal compulsion influences the fiscal policy while monetary policies don’t influence by these factors.

The steps taken by the Federal Reserve as a part of overall fiscal policy given below −

Decrease the tax rate − The disposable income will be increased by the decrement in the tax rate. This increased income will help to raise the consumer demand, production levels and price levels. With this condition the economy will come out from the recession phase and start expanding.

Increase government spending − Increase in government spending refers that the more amount of money will be spending on the large infrastructure such as highways and bridges etc. It will also increase the employment, output aggregate demand which will help to increase the economy.

It can be concluded that the expansionary monetary and the fiscal policies should be adopted by the authorities during the deep recession.