Answer to Question #202575 in Macroeconomics for Akhona Klanisi

Question

Assume the economy is in a recession. Explain how each of the following policies would affect consumption, investment and national income (GDP). In each case, indicate any direct effects, any effects resulting from changes in the macroeconomic variables and the overall effect in the economy. If there are conflicting effects making the answer ambiguous, say so.

1)    How monetary policy influences aggregate demand and how these can be used to expand the economy?

Answer 1

Solution:

A recession is a period of a significant decline in economic activities spread across the entire economy, where businesses face low demand and begin to incur huge losses. As a result, businesses are forced to lower wages and cut jobs leading to high unemployment levels, including loss of income.

During a recession, the government may adopt two main policies, which are expansionary fiscal policy and contractionary fiscal policy, while the banks may adopt a monetary policy to tackle the effects of the recession.

Expansionary fiscal policy involves tax reductions and increased government spending intended to increase aggregate demand and spur economic growth. Expansionary fiscal policy increases consumption by raising disposable income through cuts in personal income taxes or payroll taxes. Investment is also increased through raising after-tax profits through cuts in business taxes. The national income (GDP) is also increased since the level of aggregate demand is increased.

 

Contractionary fiscal policy involves tax increases and decreased government spending intended to reduce inflation, which will result in a decreased output and lower price levels. Contractionary fiscal policy decreases the level of consumption by reducing disposable income through increases in personal income taxes or payroll taxes. Investment is also decreased due to the reduction in after-tax profits with tax increases. The national income (GDP) is also reduced since the level of aggregate demand is decreased.

 

Monetary policy involves cutting interest rates to reduce the cost of borrowing and encourage investment. It also stimulates consumer spending, increasing consumption.

 

1.). Monetary policy influences aggregate demand by impacting the money supply in the economy, which affects the interest rates and the inflation rate, including some components of the aggregate demand such as investment and consumption levels.

Monetary policy can be used to expand the economy by raising the quantity levels of money supply into the economy, lowering interest rates, and stabilizing inflation, all of which can reduce the cost of investment, increase consumer spending, increase the aggregate demand and hence boost the economy.