Answer to Question #65628 in Macroeconomics for James

Question

What were the monetary and fiscal policy responses to the Great Recession? What were some of the reasons suggested for why those policy responses didn't seem to have as large an effect as anticipated on unemployment and GDP growth

Answer 1

Fiscal policy was used to stimulate the aggregate demand in response to the Great Recession. Such action as government spending increase and tax cuts were used to boost households’ income and spending. However consumer sector was in a deleveraging mode and high saving propensity (GDP multiplier was less than one) cased more government debt creation than income.

Monetary Policy Responses were aimed to influence the level of economic activity by increasing the money supply. The Fed lowered the discount rate and bought debt from financial institutions providing them money instead of debt that had uncertain value. The increase in monetary base by assets purchasing programs had to ramp up lending. However money supply multiplier was negative. Hence, despite the biggest expansion of bank cash reserve, loans from commercial banks declined as a result of insufficient bank capital in the Great Recession.

Therefore, GDP multiplier that was dwindling near zero and negative money supply multiplier nullified the basis for fiscal and monetary policy.