EXPANSIONARY MONETARY POLICY—A CURE FOR RECESSION

Sometimes, a country does experience a decline in economic activity. if this decline continues for two consecutive quarters, it is called a recession.

More appropriately, a recession is a period of a significant decline in the economic activity of a country.

A recession is usually taken to be a fall in GDP in two consecutive quarters.

A recession is usually characterized by an increase in cyclical unemployment and a deficiency in aggregate demand.

A simple strategy to eliminate recession is to increase aggregate demand or aggregate output as measured by Gross domestic product (GDP)

This is exactly what the central bank seeks to achieve when it expands the money supply.

When the central bank increases the money supply to stimulate the economy, this is known as expansionary monetary policy.

More appropriately, expansionary monetary policy is an increase in the monetary supply so as to stimulate the economy.

To cure the recession, four expansionary monetary policies are used by the central bank, namely; decreasing bank rate, decreasing cash reserve ratio, buying government securities and decrease in margin retirements.

1. Decrease bank rate: Bank rate is the interest rate at which the central bank provides loans for commercial banks.

To increase the money supply, the central bank will decrease the bank rate. This is because banks will be attracted to borrow more from the central bank if the bank rate is low.

And since they can easily borrow money from central banks, commercial will extend credit to businessmen and investors who want to invest. 

And because investment spending is part of aggregate output, this increases aggregate output.

Thus, we see that a reduction in bank rate increases investment spending, which leads to an increase in aggregate output or GDP.

2. Decrease in cash reserve ratio: As all bankers know, the cash reserve ratio is the minimum amount of money that banks must keep in reserves against cash deposits.

Commercial banks will have more money to lend to businessmen and industrialists if the central banks lower the cash reserve ratio.

This means investment spending will rise, which will have an expansionary effect on aggregate output and aggregate demand.

3. Buying of government securities: Central bank also trades securities in the stock exchange market. This is collectively known as open market operations.

When the central bank buys securities in the open market, the central bank paid cash funds to the bank which increases the bank's cash reserve.

With more cash reserves, banks extend their credit to the general public. And because people now have enough funds to expand aggregate demand increases

4. Decrease margin requirement: Margin requirement is the difference between the loan amount and the market value of security pledged as collateral for the loan.

For example, if the margin requirement is 20%, then borrowers must provide €120,000 in collateral to obtain a €96,000 loan 

Assuming, the central bank lowers the margin requirement to 10%, borrowers will be able to obtain a loan of €108,000 with the same €120,000 worth of securities.

As a result, the demand for loans will rise as borrowing becomes more affordable. The ultimate result is that there will be an increase in aggregate demand and output.

Bottom line

An expansionary monetary policy can be used to cure the recession. 

The rationale for this is that expansionary monetary policy reduces interest rates. As the interest rate decreases, consumers and businesses are encouraged to spend more on consumption and investments which is exactly what the economy needs to recover from the recession.

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