Question

Carefully explain how monetary policy can be used to counter a recession. Explain what the central bank does as well as how its actions affect the economy. Under what circumstances is fiscal policy especially useful?

Answer 1

Recession is a situation where the economic activity, basically the productivity, come to a halt. Price fall, investment fall, and AD also decline.

In such a situation monetary policy can be used by injecting the money into the economy. The expansionary monetary policy is required from the side of Central Bank. Central Bank starts buying bonds from the market and injects the liquidity through this process. This is called Open Market Operation.

By increasing the money supply the credit availability in the banking system is more which will lead to more investment and thus the AD kicks up. AD will thereby increase the output level.

The fiscal policy is also a useful tool in such a situation. AD can be supplemented by the government spending which will invite more investment and output starts picking up. This thing also creates employment.