How can monetary policy address recessionary gaps?

Monetary policy can address recessionary gaps by lowering interest rates to stimulate economic activity and increase aggregate demand.

Monetary policy, managed by a country's central bank, involves the manipulation of interest rates and money supply to control inflation and stabilise the economy. In the face of a recessionary gap, where actual output is less than potential output, monetary policy can be used to stimulate economic activity and close the gap.

One of the primary tools of monetary policy is the adjustment of interest rates. Lowering interest rates makes borrowing cheaper, which encourages businesses to invest and consumers to spend. This increase in investment and consumption can boost aggregate demand, leading to an increase in economic output. For example, a business might take advantage of low interest rates to borrow money and invest in new machinery, which could increase production and potentially create new jobs. Similarly, consumers might be more inclined to take out loans for big-ticket items like cars or houses, which can also stimulate economic activity.

Another tool is open market operations, which involve the buying and selling of government bonds. When the central bank buys bonds, it injects money into the economy, effectively increasing the money supply. This can lower interest rates and stimulate spending and investment, helping to close the recessionary gap.

Quantitative easing is a more unconventional tool that central banks might use during severe recessions. This involves the central bank creating new money to buy assets like government bonds. This can lower long-term interest rates and encourage spending and investment.

However, it's important to note that monetary policy isn't a magic bullet. It can take time for changes in monetary policy to filter through the economy, and there's always the risk that businesses and consumers might not respond to lower interest rates as expected. For example, during periods of economic uncertainty, businesses might be reluctant to invest, even if borrowing is cheap. Similarly, consumers might choose to save rather than spend, particularly if they're worried about job security. Despite these challenges, monetary policy remains a key tool for managing the economy and addressing recessionary gaps.