Monetary Policy is often employed during recessions to try and stimulate aggregate demand by reducing interest rates in the banking system. The effectiveness of these policies, however, depends on just how responsive the private sector is to decreases in the interest rate initiated by the central bank.
During mild recessions, when Investment demand is still relatively strong and businesses will respond to lower interest rates by demanding more funds for capital investments, expansionary monetary policy can be relatively effective at stimulating aggregate demand and moving the economy back towards its full employment level of output. However, if a country is in a deep recession, then investment demand will be weak and businesses will be relatively unresponsive to lower interest rates, as low confidence and the expectation of future deflation creates a strong incentive to save, rather than invest.
This lesson will use the money market diagram and the investment demand curve in the loanable funds market to evaluate the effectiveness of monetary policy during recessions. Based on this evaluation, we can better understand the circumstances under which expansionary fiscal policy may be justified, despite its effect on deficits and debt.