Chapter 14: Problem 26

Which kind of monetary policy would you expect in response to recession: expansionary or contractionary? Why?

Short Answer

Expert verified

In response to a recession, an expansionary monetary policy would be expected. This is because the main priority during a recession is to stimulate economic growth, reduce unemployment, and improve consumer and business sentiments. Expansionary monetary policy, by increasing the money supply and lowering interest rates, encourages borrowing, spending, and investment, leading to economic recovery.

Step by step solution

Introduction to Monetary Policy

Monetary policies are the actions taken by a central bank to influence a country's money supply and interest rates. Monetary policies can be classified into two types: expansionary and contractionary.

Expansionary Monetary Policy

Expansionary Monetary Policy involves increasing the money supply and lowering interest rates. This is primarily done by purchasing government securities, reducing the reserve requirements for banks, and lowering the policy rate or lending rate for targeted loans. The main goals of expansionary monetary policy are to encourage borrowing, spending and investment, which eventually stimulates economic growth and reduces unemployment.

Contractionary Monetary Policy

Contractionary monetary policy, on the other hand, is aimed at reducing the money supply and increasing interest rates. This can be achieved by selling government securities, increasing reserve requirements for banks, and raising the policy rate or lending rate for targeted loans. The main objectives of contractionary monetary policy are to control inflation, ensure stability in the financial sector, and promote adequate allocation of resources in the economy.

Recession and Monetary Policy

A recession is a period of reduced economic activity characterized by negative growth in gross domestic product (GDP) for two consecutive quarters, lower employment, and reduced consumer spending. During a recession, central banks aim to revitalize the economy by stimulating demand and restoring confidence in the financial sector.

Expected Monetary Policy in Response to Recession

In response to a recession, an expansionary monetary policy would be expected. This is because, during a recession, the main priority is to stimulate economic growth, reduce unemployment, and improve consumer and business sentiments. Expansionary monetary policy, by increasing the money supply and lowering interest rates, would encourage borrowing, spending, and investment, thereby leading to economic recovery.

Conclusion

In summary, an expansionary monetary policy would be expected in response to a recession as it aims to stimulate economic growth, reduce unemployment, and boost consumer spending. This type of policy would be more effective in addressing the issues associated with a recession than contractionary monetary policy, which focuses on controlling inflation and promoting stability in the financial sector.

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