Monetary Policy: Addressing Recession Research Assignment (Essay Sample)

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Monetary Policy: Addressing Recession
Introduction
The economic development of any particular country reflects the well-being of its citizens. An economically stable country is able to give proper services and feed its people. In most cases, the Gross Domestic Product (GDP) is used to measure the state of the economy. GDP is also applicable when comparing the economic prowess of one country with another. It is the responsibility of any particular government to manipulate and control the growth of its economy. There are two major tools that are used in stimulating or slowing down economic growth in different countries. These are fiscal policies and monetary policies. The two are techniques initiated by the government in a bid to control inflation, unemployment or any other negativity that comes with inflation or a recession. This paper focuses primarily on monetary policy as a tool to pull an economy out of a recession and stimulate growth.
Meaning of a Recession
A recession refers to the period when an economy experiences a general fall in the GDP. This happens in two successive quarters of economic growth. There is a general fall in the industrial and trade activity in the affected country. A recession is mostly described with the conditions that it brings in a country (Miles 4). To begin with, the unemployment rates soar and industrial activity undergoes a persistent contraction. This means that industries have to lay off some of the workers as production falls. The result is that a significant percentage of the labor force would be jobless. This leads to reduced income since individuals become dependents on the working population. The demand for goods and services decrease to as a result. There is a general decrease in the standards of living for everyone (Kiyotaki, Nobuhiro, and Moore).
Other characteristics of a recession include the reducing prices of assets; for instance, the prices of houses and land decrease significantly. Also, government borrowing, both from the local and foreign sources, increases considerably. Still, due to decreased demand, firms perform a destocking exercise where the spare stock is sold out at throw away prices. Heavy discounting follows implying that the prices of all goods fall. Inflation is low during this phase of the business cycle (Kiyotaki, Nobuhiro, and Moore 8).
Monetary Policy and Fiscal Policy
The two terms can be used interchangeably to address recession. Fiscal policy refers to the deliberate actions by the government aimed at stimulating economic growth. Such actions involve the manipulation of taxes and government spending in a bid to reverse the situation. The end result is a stimulated growth. Lowering of taxes accompanied by increased government spending increases aggregate demand, which in turn stimulates growth.
On the other hand, monetary policy involves the manipulation of money supply and interest rates especially through the central bank to control inflation or a recession. Money supply in an economy can influence the direction in which the business cycle heads. Too much money circulating in the economy brings about a decreased value for the same. As such, the prices of goods and services soar to high levels, resulting in inflation. Still, too little money in the economy brings about increased demand for the commodity. This results in a situation where the value for money is high. The central bank is instrumental in the control of the supply of money in the market. There are various methods used by the central bank in carrying out this function:
Bank rate: This refers to the rate of interest charged by various banks for any loans advanced to individuals and firms. The central bank has the powers and the mandate to control the interest rates charged. In cases of high money supply in the market, the central bank increases the interest charged by commercial banks. This is done indirectly by increasing its own interest rates it charges on other banks. As such, to remain in business and foster profits, commercial banks are forced to increase their interest rates. The result is that less and less people would be willing to acquire loans from banks. The cost of capital would be just too high. The money supply in the market consequently goes down to desired levels.
In cases of low money supply in the market, the central bank drives the interest charged by banks downwards. As a result, the cost of capital lowers and more people are attracted to obtaining money from banks. The result would be increased money supply in the market. Such loans are mainly meant for investment purposes (Mahadeva, Lavan and Gabriel 14).
Open market operations (OMO): In open market operations, the government takes to buying and selling of securities to either increase or reduce the supply of money in the market. It is the sole responsibility of the central bank to advice the government on the direction of the money supply, and the measures to take. When the supply of money is high, the government sells its securities at attractive prices to the public. The result is that, as people and firms use cash to buy such securities, the amount of money available in the market goes down.
In the opposite case where the supply of money in the economy is high, the government buys back its securities from the public. This way, they are converted into cash in the market and money supply increases to desired levels (Mahadeva, Lavan and Gabriel 17).
Cash reserve ratio: The cash reserve ratio is the amount of money that is legally required of commercial banks to keep with the central bank. It is usually expressed as a percentage of the total deposits in each individual bank. This amount is subject to change based on the prevailing market conditions, and the central bank has the mandate to adjust it. Such adjustments are done to control the supply of money in the market. The main assumption of this form of control is that investment capital is what determines money supply. The commercial banks are also required to maintain a given level of liquidity or cash in their vaults, an amount that cannot be lent out.
When the supply of money is high, the central bank increases the amount required of commercial banks to keep in reserve. This way, the amount of cash available at the banks for lending is low. Some of those seeking loans are therefore turned away. The supply of money in the market falls.
In the case where money supply is low, the central bank decreases the amount that commercial banks are meant to keep in reserve. More funds are therefore available for lending to the general public. As such, firms and individual have more access to investment funds and money supply in the market increases as a result (Mahadeva, Lavan and Gabriel 20).
How Monetary Policy Brings Recession to an End
The Keynesian theory put forward a situation where the economy will always experience highs and lows. There are four quarters that are used to describe the business cycle. There are therefore four different phases that describe the economy, and all characterized by different extremes of economic change, either positive or negative.
A recession mostly is initiated by efforts by the government to decrease the rate of economic growth. When the rate is too high, a period mainly referred to as a boom, the rate of inflation tends to be too high. This is because the economy is experiencing a lot of expansion, unemployment rates are low and income is high (Miles 6). There is therefore surplus cash available to households to spend on goods and services. The implication is that the aggregate demand is at its peak.
In a bid to control the negative effects of a fast growing economy such as inflation, the government sets monetary policy into operation. The main aim is to balance the money supply and demand. There are two major techniques applied in monetary policy to reduce economic stimulation: increasing interest rates and controlling money reserves held by banks. This results in controlled flow of money into the market (Miles 8).
Reduced money supply decreases the rate of new investments in the economy. This results in decreased job opportunities, and a general reduction in aggregate demand. The demand for money increases, interest rates go up and industrial activity contracts. The overall result is decreased industrial and trade activity, which leads to slowing down of industrial growth. If this continues beyond one quarter of the business cycle, the result is a recession.
A recession is a period of declining economic growth. Sometimes, the economic growth can be too low to the point that it is mistaken for a recession. For instance, a 0.5% growth rate is too low to be noticed by people, and can often be described as a recession. A recession is usually the preceding phase as the country heads i...