Question

anomics (Summer 2020) sec 01 ution when there is a recessionary gap in the economy. What monetary and pe the problem? Explain 8? Next page

Answer 1

Answer to the question:

Recessionary gap is a situation where the real GDP is less than the potential GDP in an economy at the full employment level. The economy at a recessionary gap operates below full employment level. It is a situation which slows down the economic activity and bring contraction in the business cycle. When business cycle starts contracting employment, income and output starts decreasing. Employment, income and output are interlinked with each other. As investment decreases it reduces the employment level as a result output decreases. As employment decreases the income level also decreases in the economy and this in turn reduces decreases consumption of the people. In a recessionary gap aggregate demand is lower than the aggregate supply.

In case of recessionary gap fiscal and monetary polices are very helpful to bring back the economy to a better position. We will discuss both the fiscal and monetary policy each in turn.

Fiscal policy:

Fiscal policy refers to the use of either taxes or government spending in order to stabilise the economy. Expansionary fiscal policy is very effective in a situation like recessionary gap. Expansionary fiscal policy implies either increase in government spending or decrease in taxes.

A reduction in the tax increases the consumption level in an economy which in turn rises the aggregate demand. And this turn rises investment and finally employment output and income increases.

Again an increase in government spending increases the income level in the economy which in turn increases the aggregate demand and as a result it rises the employment and output and investment.

So, we can see fiscal policy is effective in case of recessionary gap.

Monetary policy:

Monetary policy includes changes in money supply and changes in nominal interest rate in an economy. During recessionary gap government can either increase money supply or lower the interest rate.

If the government increases the money supply it will increase income, aggregate demand and output in an economy. This will help the economy to fight with recessionary gap.

Agian, if the government decreases the interest rate, then it will attract investors to invest in the economy. As a result employment income, aggregate demand and output will rise.

So we can see that monetary policy is also very much effective in case of recessionary gap.

So, in conclusion it can be said that,both the monetary and fiscal policy are effective to fight with recessionary gap.