Question

Which kind of monetary policy would you expect in response to recession: expansionary or contractionary? Why?

Short answer

During a recession, the central bank should implement an expansionary monetary policy to stimulate economic growth and restore growth. This policy increases the money supply, lowers interest rates, and encourages consumer and business spending, ultimately helping the economy to recover from the recession. In contrast, contractionary monetary policy would slow down the economy and potentially worsen the recession.

Step-by-step solution

Identify the purpose of monetary policy during a recession

: During a recession, the economy experiences slower economic growth, higher unemployment rates, and a general decline in business activity. The main goal of the central bank's monetary policy in this situation is to stimulate the economy and restore growth.

Understand expansionary monetary policy

: Expansionary monetary policy is implemented by a central bank to increase the money supply and stimulate economic growth. This is done mainly through lowering interest rates, purchasing government bonds, and increasing the reserve requirements for banks. Lower interest rates make it cheaper to borrow money, encouraging consumer spending and business investments. Additionally, purchasing government bonds inject new money into the economy.

Understand contractionary monetary policy

: Contractionary monetary policy aims to reduce inflation by slowing down the growth of the money supply. This is achieved by increasing interest rates, selling government bonds, and increasing the reserve requirements for banks. Consequently, higher interest rates make borrowing more expensive, and money supply growth is reduced. This policy is generally used when the economy is overheating, and not during a recession.

Choose the appropriate monetary policy for a recession

: To combat a recession, the central bank should implement an expansionary monetary policy. This is because its primary goal is to stimulate economic growth, reduce unemployment rates, and encourage consumer spending.

Explain the reasoning behind the choice

: Expansionary monetary policy is the best choice during a recession because it aims to increase the money supply, lower interest rates, and encourage consumer and business spending. By doing so, it helps to boost economic growth and employment, ultimately allowing the economy to recover from the recession. In contrast, contractionary monetary policy would have the opposite effect, slowing down the economy and potentially exacerbating the recession.