Answer to Question #203280 in Macroeconomics for SANDILE

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.

a)    How fiscal policy influences aggregate demand and how these can be used to expand the economy? [15 Marks]

b)    How monetary policy influences aggregate demand and how these can be used to expand the economy? [15 Marks]

Answer 1

a)

Expansionary fiscal policy can be used to kick-start an economy during a period of recession. Expansionary fiscal policy boosts aggregate demand, consequently output and employment increases. Fiscal policy stimulates demand in a recession by causing stimulation in economic growth while keeping interest rates low. As a result, well-targeted, deficit-financed stimulus measures encourage new investment despite increasing the deficit.

A government can use fiscal policy to stimulate growth in the economy by increasing spending for goods and services. This increases demand for goods and services increases demand and consequently production must go up. when production goes up, companies need to hire more people creating employment and now the initially unemployed people acquire more money to spend on goods and services.

This further increases the demand and there is need for more production. Consequently, government spending tends to speed up economic growth.

b)

During recession, expansionary monetary reduces interest rates shifting aggregate demand to the right and leading to the new equilibrium at point where there is a higher potential GDP level of output with a relatively small rise in the price level.

Banks use the expansionary monetary policy to stimulate the economy during recession by expanding monetary supply which in turn results in lower interest rates and borrowing costs consequently boosting consumption and investment.