1.Compare and contrast monetary and fiscal policy in thecontext of an economy experiencing a recessionarygap . What are the policy options of each and how does each policy work?What are the...

2. Compare and contrast monetary and fiscal policy in the context of an economy
experiencing a recessionary gap . What are the policy options of each and how does
each policy work? What are the advantages and disadvantages of using either
monetary or fiscal policy? After your general discussion, recommend a specific,
detailed policy for addressing the current recessionary gap. Use an AD-AS diagram
(draw and scan or create on your computer) to show the short run and long run
effects of using the policy you chose.
Answer:
Recessionary gap is defined as the situation in which there is demand deficiency in
the economy i.e. the situation where current level of aggregate demand is less the
full employment level of aggregate demand. We can represent this situation by the
figure1. In this figure, AD’ curve represent full employment (Y*) level of aggregate
demand whereas AD represent current level of aggregate demand. With current
level of aggregate demand (AD), the output is Y1 which is less than the full
employment level of output (Y*). This means that the economy is suffering from
recessionary gap and this recessionary gap is given by the difference between
current output level (Y1) and full employment output level (Y*).
Figure1:
Fiscal policy concerns with government expenditure and taxes and therefore it is
conducted by government. There are mainly two tools of fiscal policy; government
expenditure and taxes. Monetary policy, on the other hand, is conducted by central
bank of an economy and is related to money supply in that economy i.e. central
bank, through its monetary policy, manages or controls the money supply in the
economy. There are three main tools of money supply; discount rate, open market
operation and reserve requirement.
In case of recessionary gap, both central bank and government should follow
expansionary policies. Specifically, the government should follow expansionary
fiscal policy while the central bank should follow expansionary monetary policy.
The government would conduct expansionary fiscal policy by either reducing taxes
or increasing government expenditure or by both. Lower taxes imply higher
disposable income (income left after paying personal taxes) which would lead to
increase in consumption expenditure. Since both the things i.e. government
expenditure and consumption expenditure are important components of aggregate
demand, therefore increase in these elements (because of expansionary fiscal
policy)...