Question

Stabilization policies are often used to bring about economic equilibrium: 1. Monetary policy is implemented by the Bank of Canada (or Central Bank) - Manipulation of short-term interest rates - Management of the money supply 2. Fiscal policy is the responsibility of the Department of Finance and the Treasu Board - Government spending levels - Government deficit and borrowing policies Question: How would each of these policies tools be deployed to address a recessionary gap? An inflationary gap?

Answer 1

When an economy is in a recession, expansionary fiscal policy is in order. Typically this type of fiscal policy results in increased government spending and/or lower taxes. A recession results in aggregate demand to be at a level lower than it would be in a full employment situation. In order to close this gap, a government will typically increase their spending which will directly increase the aggregate demand curve (since government spending creates demand for goods and services). At the same time, the government may choose to cut taxes, which will indirectly affect the aggregate demand curve by allowing for consumers to have more money at their disposal to consume and invest. The actions of this expansionary fiscal policy would result in a shift of the aggregate demand curve to the right, which would result closing the recessionary gap and helping an economy grow.

In a recession, monetary policy will involve cutting interest rates to try and stimulate spending and investment. It should also weaken the exchange rate which will help exports. But it can also be prove ineffective due to liquidity trap. Which may arise due to

• Banks had insufficient credit so were unwilling to lend – despite low-interest rates.
• Confidence was very low.
• House prices were falling reducing consumer wealth.
• With deflation, low-interest rates may be insufficient, because falling prices can still make real interest rates quite high. Therefore, in times of deflation, zero interest rates may not get an economy out of recession.

Inflationary gap

When aggregate demand exceeds aggregate supply.

Fiscal policy helps in inflationary gap through decreasing the number of funds circulating within the economy. This can be accomplished through reductions in government spending, tax increases, bond and securities issues, interest rate increases and transfer payment reductions.

These adjustments to the fiscal conditions within the economy can help restore economic equilibrium. By shifting the overall demand for goods, the adjustments control the amount of funds available to consumers. As the amount of money within an economy decreases, the overall demand for goods and services also declines.

Monetary policy can be used to contract the money supply in the economy by raising interest rates, which would reduce purchasing power, resulting in falling demand.