Question

Questions: a) Select a monetary policy instrument and explain how to use the instrument to implement monetary policy to ease the effects of a severe recession. b) Use the concept of the cause chain effect to indicate (e.g. rise, fall and or stay the same) how each of the following will be effected with this policy. i) Excess reserves il) Money Supply iii) Interes rates iv) Investment v) Aggregate demand vi) Real GDP

Answer 1

Monetary Policy is used to affect the cost and availability of money supply. Following tools are used to correct economic recession.:

• Reserve Requirement.
• Open Market Operation.
• Discount Rate.

Open market operation is the most effective way to deal with the recession and it is the most frequently used tool.

Open Market Operation: To deal with the Recession, Central Bank would buy securities from the open market. it releases money into the market. It increases the lending capacity of banks. Thus, the money supply increases. so there is a fall in interest rate prevailing in the market.

A fall in interest rate raises investments. So now more economic activities would drive up the real GDP of country.

Reserve Requirements: Reserve requirements are part of deposits that are kept with Federal Reserve. these reserve requirements reduce the capacity of commercial banks to lend out money.

If reserve requirements are reduced, the lending capacity of bank increases, so interest rate goes down and investment rises up

The high investment raises the level of real GDP of the country.

Discount rate: it is the rate at which the central bank lends out to commercial banks. if such rates are reduced, there will be a rise in money supply, so the interest rate decreases. Thus investment increases and the rise in investment would cause rise in the GDP of the country.