Expansionary Monetary and Fiscal Policies and Output Gap Closures for Recessionary Output Gaps

Expansionary Policies and the Negative Output Gap

• Conceptual Overview of Recessionary States:     * An expansionary policy is necessary when the economy is experiencing a recessionary or negative output gap.     * In a negative output gap, actual output ($Y_1$) is less than the full-employment output level ($Y_F$).

The Money Market at Equilibrium and Expansionary Shifts

• Initial Equilibrium State:     * The money market is defined by the intersection of the Money Supply ($MS$) and Money Demand ($MD$) curves.     * The vertical axis represents the Nominal Interest Rate ($NIR$).     * The horizontal axis represents the Quantity of Money (Q \text{ of } \).
• Money Supply Shift:     * To close a recessionary gap, the central bank shifts the Money Supply to the right (from $MS_1$ to $MS_2$).     * Effect on Interest Rates: This increase in the money supply results in a decrease in the Nominal Interest Rate ($NIR \downarrow$).
• Feedback Loops Between AD/AS and Money Demand:     * When expansionary policies are implemented, Price Level ($PL$) and Output ($RGDP$) increase.     * This increase in Price Level and Real Output leads to an increase in the demand for money ($MD$), as consumers and businesses require more cash for transactions and to account for higher prices.

Aggregate Demand/Aggregate Supply (AD/AS) at a Negative Output Gap

• Visualizing the Recessionary Gap:     * The economy is in a short-run equilibrium at an output level of $Y_1$, which is to the left of the Long-Run Aggregate Supply ($LRAS$) curve at $Y_F$.     * The Short-Run Aggregate Supply ($SRAS$) and Aggregate Demand ($AD$) intersect at $Y_1$.
• Policy Intervention Goal:     * The objective is to shift the Aggregate Demand curve ($AD$) to the right to close the gap between $Y_1$ and $Y_F$.     * Shift Mechanism: Increases in Consumption ($C$), Investment ($I$), Government Spending ($G$), or Net Exports ($X - M$).

Monetary Policy with Limited Reserves

• Policy Tools to Close the Output Gap:     * Discount Rate:         * The central bank should Decrease the Discount Rate.         * Short-Run Effect on Money Supply ($MS$): Increase ($\uparrow$).         * Short-Run Effect on Nominal Interest Rate ($NIR$): Decrease ($\downarrow$).         * Short-Run Effect on Aggregate Demand ($AD$): Increase ($\uparrow$).     * Reserve Requirement:         * The central bank should Decrease the Reserve Requirement.         * Short-Run Effect on Money Supply ($MS$): Increase ($\uparrow$).         * Short-Run Effect on Nominal Interest Rate ($NIR$): Decrease ($\downarrow$).         * Short-Run Effect on Aggregate Demand ($AD$): Increase ($\uparrow$).     * Open Market Operations (OMO):         * The central bank should Buy Bonds.         * Short-Run Effect on Money Supply ($MS$): Increase ($\uparrow$).         * Short-Run Effect on Nominal Interest Rate ($NIR$): Decrease ($\downarrow$).         * Short-Run Effect on Aggregate Demand ($AD$): Increase ($\uparrow$).

Fiscal Policy Actions for Recessionary Gaps

• Transfer Payments:     * Action: Increase specific transfer payments (e.g., social security, subsidies).     * Short-Run Effect on Aggregate Demand ($AD$): Increase ($\uparrow$).     * Short-Run Effect on Unemployment: Decrease ($\downarrow$).     * Short-Run Effect on Price Level ($PL$): Increase ($\uparrow$).
• Automatic/Government Spending:     * Action: Increase direct Government Spending ($G$).     * Short-Run Effect on Aggregate Demand ($AD$): Increase ($\uparrow$).     * Short-Run Effect on Unemployment: Decrease ($\downarrow$).     * Short-Run Effect on Price Level ($PL$): Increase ($\uparrow$).
• Taxes:     * Action: Decrease personal or corporate income taxes.     * Short-Run Effect on Aggregate Demand ($AD$): Increase ($\uparrow$).     * Short-Run Effect on Unemployment: Decrease ($\downarrow$).     * Short-Run Effect on Price Level ($PL$): Increase ($\uparrow$).

Monetary Policy with Ample Reserves

• Instrumented Rate Adjustment:     * In a framework of ample reserves, the Central Bank lowers its administered rates to enact expansionary policy.     * Specific rates lowered include the Interest on Reserves (IOR) and the Discount Rate.
• Transmission Mechanism:     * Lower administered rates ($\downarrow$) lead to lower overall Interest Rates in the economy.     * Lower Interest Rates lead to an increase in Investment Spending ($I \uparrow$).     * Increased Investment Spending leads to an increase in Aggregate Demand ($AD \uparrow$).
• Graphical Representation (Reserve Market):     * Vertical axis: Policy Rate ($5\%$ represented as an example).     * Horizontal axis: Quantity of Reserves.     * The policy rate floor is set by the administered interest rate (e.g., $IOR$).

Long-Run Economic Adjustment Without Intervention

• The Self-Correction Mechanism:     * If no government or central bank intervention occurs during a negative output gap (Y_1 < Y_F), the economy will eventually self-correct through adjustments in the labor and factor markets.
• Transition Factors:     * Input prices, most notably nominal wages, will decrease as workers accept lower pay due to high unemployment.     * Inflationary expectations will also decrease.
• Shift in Supply:     * Reduced production costs (lower wages) cause the Short-Run Aggregate Supply ($SRAS$) curve to increase (shift to the right from $SRAS_1$ to $SRAS_2$).
• Final Result:     * The Price Level decreases from $PL_1$ to $PL_2$.     * The economy returns to the full employment output level ($Y_F$) at a lower equilibrium price level.     * Equation path: ($Y_1 \text{ (recession)} \rightarrow Y_F \text{ (full employment)}$).