Question

Suppose an economy is facing a recessionary gap. What kind of monetary policy should the government follow? Show how this will effect the bond market, the money market, the foreign exchange market, and the AS-AD model.

Answer 1

RECESSIONARY GAP- recessionary gap is a situation when there is AS>AD and therefore there is excess supply of goods and services in the economy.as a result production needed to be stopped due to lack of effective demand and thus unemployment increases in the economy as a result the economy enters into the recession. the difference between present point of equilibrium and the full employment level is stated as recessionary or deflationary gap.

momentary policy to be followed- government needs to increase the money supply in the economic.central bank of a country can execute some basic points as mentioned below-

1. decrease REPO rate
2. decrease in margin requirement
3. purchase securities from open market
4. providing loan at a cheaper rate
5. decrease in cash reserve ratio.

impact on bond market- bond market shows a negative relationship with respect to monetary policy. when central bank undertakes monetary policies implementation then the yield of the bond declines and government generate funds to invest as public spending in the economy.

therefore it can be concluded that-

expansionary monetary policy declines the interest rate of bonds

and it declines the yield of the bond.

IMPACT ON MONEY MARKET-

when the monetary policies are implemented then there is movement of funds towards a more productive sector which is transferred generally to producer sector.it creates a push in economic growth.

but also the supply side is representing a opposite reaction because of the less return over the investment ,therefore government need to use the reserve to fulfill the demand side.therefore government purchases securities from open market sources and as a result supply of money is increased and thus the rate of interest declines assuming the constant demand. we can understand the concept with AD and AS concept.

IMPACT ON FOREIGN EXCHANGE MARKET-

when government adapts a monetary policy towards the increase in supply of the market and then it decrease the real interest rate in the economy and the financial investment and portfolio investment loses its grace and it  discourages the domestic as well as the foreign investor therefore foreign investors avoid investing in that country and the domestic investor also seek various alternative options of investment somewhere else particularly in some other countries. thus the demand for foreign currency is increased in the economy.