Answer to Question #159307 in Macroeconomics for Saif Ur Rehman

Question

COVID-19 all around the world has restricted the economic activity. To stop the spread of the virus Pakistan like many other countries adopted the policy of smart lockdown. Shutting down of the industry has created adverse supply shock in the economy. While, the slowdown in business and economic activities the country is in the recessionary phase of the business cycle as the GDP growth for the FY 2020-21 is expected to be -0.2 accompanied by high unemployment and poverty rate.

a.    Reflecting on the above situation justify whether the State Bank of Pakistan should opt for easy or tight monetary policy as a stabilization policy. Also illustrate it graphically.                                                                                

b.    Reflecting on the above situation justify whether the Government of Pakistan should opt for expansionary or contractionary fiscal policy as a stabilization policy. Also illustrate it graphically.                                                         

Answer 1

a. The government should opt for an easy monetary policy

An expansionary monetary policy is a type of macroeconomic monetary policy that aims to increase the rate of monetary expansion to stimulate the growth of the domestic economy. The money injection boosts consumer spending, as well as increase capital investments by businesses.

Expansionary Monetary Policy

An expansionary monetary policy is generally undertaken by a central bank or a similar regulatory authority.

Tools for an Expansionary Monetary Policy

Similar to a contractionary monetary policy, an expansionary monetary policy is primarily implemented through interest rates, reserve requirements, and open market operations. Lower the short-term interest rates

The adjustments to short-term interest rates are the main monetary policy tool for a central bank. By decreasing the short-term interest rates, the central bank reduces the cost of borrowing to commercial banks.

Subsequently, the banks lower the interest rates they charge their consumers for loans. It may decide to buy large amounts of the government-issued securities (e.g., government bonds) from institutional investors to inject additional cash into the domestic economy.

Effects of Expansionary Monetary Policy

An expansionary monetary policy can bring some fundamental changes to the economy. Stimulation of economic growth.

An expansionary monetary policy reduces the cost of borrowing. Therefore, an expansionary monetary policy generally reduces unemployment.

The expansionary policy shifts the LM curve to the right. This increases the national income from Y1 to Y2 and at the same time reduces the interest rate from i1 to i2.

b. The Government should opt for an Expansionary fiscal policy

Expansionary fiscal policy is when the government increases the money supply in the economy using budgetary instruments to either raise spending or cut taxes—both having more money to invest for customers and companies.

The objective of Expansionary Fiscal Policy

Expansionary fiscal policy is intended to boost growth to a healthy economic level, which is required during the business cycle's contractionary period. Once a recession has already arisen, it intends to end the recession and prevents depression.

How Does it Function?

By utilizing subsidies, transfer payments (inclusive of welfare programs), and tax cuts on wages, expansionary fiscal policy brings more money into the hands of consumers to give them more purchasing power.

It also lowers unemployment by contracting public works or recruiting new government employees, all of which raise demand and boost consumer spending driving nearly 70 percent of the economy. Tax cuts generate employment in this way, so if the company already has enough cash, it can use the cut to buy back stocks or purchase new businesses.

The supply-side economics theory suggests reducing corporate taxes rather than payroll taxes and supports lower capital gains taxes to boost spending by companies.

Expansionary Fiscal Policy Examples

The two significant examples include increased government spending as well as tax cuts.

The expansionary fiscal policy shifts the IS curve to the right. This increases the national income from Y to Y1 and increases the rate of interest from R to R1.