Q.25 Suppose the economy is in recess... [FREE SOLUTION]

Chapter 26: Q.25 (page 691)

Suppose the economy is in recession and the monetary policymakers lower interest rates in an effort to stabilize the economy. Use an aggregate supply and demand diagram to demonstrate the effects of a monetary easing when the transmission mechanisms are functioning normally and when the transmission mechanisms are weak, such as during a deep downturn or when significant financial frictions are present.

Short Answer

Expert verified

The following figure depicts the impact of rate cuts when the financial intermediation channels are working properly and when they are not:

Step by step solution

Concept introduction

The credit channel occurs when a fiscal policy choice has an influence on the stock markets and the whole economy.

The reserve bank acquires some governmental and other assets first from the market and expands the monetary base and cuts bond yields.

Depression is a brief time during that all business output declines for a few days, as evidenced by a drop in GDP in two consecutive quarters.

Explanation of solution.

The following figure depicts the impact of rate cuts when the financial intermediation channels are working properly and when they are not:

Where,

The positive long-run quantity produced is referred to as $L R A S$ . $S R A S$ stands for short-term quantity supplied.

The aggregate demand is abbreviated as $A D$ .

When ways of communicating are in place, fiscal stimulus may be relaxed exactly, and the quantity demanded will shift from $A D 1$ to $A D 3$ and close the annual deficit.

When monetary communications are poor, certain routes need not perform and others do not operate effectively, resulting in no or minimal shift in the total. $A D$ will move somewhat from $A D 1$ to $A D 2$ in this example, but the annual deficit would remain. This issue explains why, in certain cases, the fiscal policy fails to close the production deficit.