Answer to Question #44931 in Macroeconomics for Bernadine Angala

Question

In the broadest terms, an economy can face two possible problems-recession and excess inflation. Using your knowledge of fiscal and monetary policy, which do you think is more effective in dealing with each of these problems? Explain.

Answer 1

Recession is only one of the phases of the economic cycle, always following the boom in the economy. Greatly prolonged recession could go into a depression, but the correct state actions aimed at the prevention of depressive state of the economy, the recession may be a push to improve it. Active capital injections from the state budget is the possible way, more or less painlessly overcome recession. Expansionary monetary policy means the taking by the central bank measures to increase the supply of money, which are: reduction of reserve requirements; decrease in the accounting rate of interest; and central bank purchase of government securities. Growth in the money supply leads to an increase in aggregate demand. This ensures that the output growth to potential output and, therefore, serves as a means to overcome the recession and the use of resources at the level of full employment.

To quantify the effectiveness of the fight against inflation, a so-called loss ratio is used. It shows how many percent of the real annual output is necessary to sacrifice in order to reduce inflation by one percentage point. Proponents of the theory of rational expectations believe that the losses from fighting inflation can be significantly reduced if the plan of such anti-inflationary policy will be announced in advance, before the economic agents form their expectations, and that the most essential if people are to believe in the implementation of this plan.
Anti-inflationary policy can be carried out as a means of "shock therapy" (when the rigid monetary policy helps to quickly bring down inflation, but accompanied by a significant decline in production), and gradually, through repeated, but each time a small reduction in the rate of growth of the money supply, thus avoiding a deep recession, but does not provide with the ability to quickly bring down inflation.

More broadly, the "shock therapy" implies, as a rule, the use of a purely monetarist anti-inflation measures: extensive liberalization of economic life, freeing prices, curtailment of economic activity of the state, a hard limit of monetary growth, balancing the budget, mainly due to the reduction of social programs, and so on. Programs of gradual reduction of inflation foresee an active regulatory influence of the state (in order to mitigate the negative effects of anti-inflation measures): support of the most important industries, business tax incentives, partial regulation of the pricing process, the creation of market infrastructure, etc. In this case, the anti-inflationary reduction in aggregate demand is complemented by measures that support the proposal and creating the conditions for its growth in the future, to avoid a deep recession and unemployment (the policy of gradualism).