Definitions

• Monetary Policy: The use of interest rates and money supply by a central bank to influence aggregate demand (AD) and economic activity.
• Recessionary Gap: The difference between actual output and potential output when an economy operates below full employment.
• Aggregate Demand (AD): The total demand for goods and services in an economy at a given price level over a period of time.

Economic Theory

• A recessionary gap occurs when real GDP is below potential GDP, leading to high unemployment and low inflationary pressures.
• Expansionary monetary policy is used to reduce a recessionary gap by lowering interest rates and/or increasing the money supply.
• Lower interest rates lead to increased consumption (C). Lower borrowing costs encourage households to take loans for big purchases.
• Increased investment (I) as firms borrow more for capital investment due to cheaper credit.
• Weaker exchange rate as capital outflows reduce currency value, making exports cheaper and imports more expensive, increasing net exports (X-M).
• These factors shift AD rightward (AD1 → AD2), increasing real GDP (Y1 → Y2) and reducing the recessionary gap, as shown in the diagram.
• Initial increases in spending create secondary rounds of income and consumption, further boosting AD.

Diagram

• AD/AS Model showing AD shifting rightward from AD1 to AD2
• Increase in real GDP (Y1 → Y2), reduction in unemployment, and potential slight inflation (P1 → P2)

Evaluation

• United States (2008-2015): During the Global Financial Crisis, the Federal Reserve reduced interest rates to near 0% and engaged in quantitative easing (QE), injecting $4.5 trillion into the economy.
• In the Short-run, GDP growth rebounded from -2.5% (2009) to 2.9% (2015), and unemployment fell from 10% to 5%.
• Borrowers benefited due to lower interest costs, but savers lost out as returns on deposits fell.
• In the long-run, prolonged low interest rates created asset bubbles, particularly in housing and stock markets.
• While monetary policy was effective in stimulating AD, the economy remained reliant on cheap credit, and inflation remained below the 2% target due to weak consumer demand.
• Monetary policy is more effective when interest rates are not already low. If confidence is weak (liquidity trap), fiscal policy may be more effective.

Conclusion

• Monetary policy is effective in reducing recessionary gaps by stimulating AD, but its success depends on confidence and the initial interest rate level.
• Short-run benefits include increased growth and employment, but long-term risks include inflationary pressures and asset bubbles.
• In deep recessions (e.g., 2008), a combination of monetary and fiscal policy is often necessary for full economic recovery.

Definitions

• Interest rate: The cost of borrowing and the return on savings, usually set by the central bank.
• Aggregate demand (AD): The total demand for goods and services in an economy at a given price level over a period of time.
• Output (Real GDP): The total value of goods and services produced in an economy, measured in real terms.

Diagram

• AD/AS diagram with AD shifting rightward (AD1 → AD2)
• Increase in real GDP (Y1 → Y2) and possible increase in the price level (P1 → P2)

Explanation

• A decrease in interest rates lowers the cost of borrowing and reduces the incentive to save.
• Consumption (C) increases as households borrow more for durable goods (e.g., houses, cars) and spend more rather than saving, leading to higher consumer spending.
• Investment (I) increases as lower interest rates reduce borrowing costs for firms, encouraging capital investment, leading to higher productive capacity.
• Net exports (X-M) may rise due to lower interest rates, leading to currency depreciation (less foreign investment in domestic assets), making exports cheaper and imports more expensive, improving net exports.
• These factors increase aggregate demand (AD), shown by a rightward shift in the AD curve in the diagram.
• As AD increases, firms respond by increasing output to meet higher demand, leading to an increase in real GDP (economic growth).
• Employment rises as higher output requires more labor, reducing unemployment.
• If the economy is near full employment, increased AD may lead to demand-pull inflation.
• Overall, the decrease in interest rates leads to higher output, lower unemployment, and potential inflationary effects, depending on the economy’s spare capacity.