Macroeconomics Closing a Recessionary Gap

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a.The Policy that the Fed will implement to close the recessionary gap is called the Expansionary Fiscal policy. The Federal bank in the United States has the power to both make the laws and pass them too. If the economy is operating at a capacity lower than its optimum output, there is a recessionary gap in the economy. Thus if the general level of employment in the economy is lower than its optimum level, the output generated will also be lower. The Fed can influence the supply of money in the economy which is instrumental in dealing with recession or inflation for that matter. To take care of this gap, the Fed has various means available on hand. The Fed can take any or all of the following actions to tackle the recessionary gap: •Open market operations: These refer to purchase of Government securities such as bonds and treasury bills to control recession. •Interest Rate: This is the rate of interest that the Fed charges commercial banks for borrowing. In a recession, the Fed would reduce the interest rates at which it lends money to the commercial banks. The banks are expected to pass on this benefit further to the general public and thus it in effect reduces the market interest rate. •Reserve requirement: This refers to the proportion of deposits that commercial banks have to maintain as reserves. The banks are required to keep a certain portion of the funds deposited with them as liquid cash. This should be kept idle in the vaults of the banks and this amount is not available for further lending. For dealing with recession, the Fed would reduce the reserve requirement.

b.The above steps taken by the Federal Bank would result in reducing the recessionary gap. This can be explained as follows. •Open market operations: Purchase of Government securities and bonds would increase the money supply in the market. When the Fed starts purchasing bonds, the demand for bonds will increase leading to a hike in their prices. The money supply in the hands of...
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