[MUSIC] Well we have already learned how to use fiscal policy to quite precisely close a recessionary or inflationary gap. For example, how much would you increase government expenditures to close a $100 billion recessionary gap if the marginal propensity to save in the economy were 0.25? Take a quick minute here to jot down your answer and then I'll explain why I'm even asking you this question when we're talking about monetary policy. [MUSIC] Okay this question is easy, if the MPS is 0.25 it gives us a Keynesian multiplier of 4, so to close the recessionary gap you just need to increase government expenditures by $25 billion, easy peasy. But here's the deal, while we can similarly use monetary policy to close recessionary and inflationary gaps, we cannot do that with anywhere near the apparent precision of fiscal policy. That's because monetary policy only works its magic not directly, but indirectly through a key concept known as the monetary transmission mechanism. [MUSIC] Of course I have already alluded to this monetary transmission mechanism numerous times, however let's illustrate its multi-step process more formally now. So let's first suppose that your nation's central bank wants to close an inflationary gap in the economy using open market operations. My first question as a refresher is this will the central bank buy bonds on the open market, or sell bonds on the open market to close the inflationary gap? Take a minute now to answer that question and as you do so try to draw on a piece of paper or your computer how a change in the money supply would ripple through the economy in multiple steps and affect real GDP and inflation. [MUSIC] Okay, here's the multi-step monetary transmission mechanism. Step one, the central bank sells bonds on the open market. And step two, this contracts the money supply, m. This is in turn in step three causes interest rates to rise and the domestic currency to strengthen. The result in step four is a reduction in both the business investment and net exports in the GDP growth equation. Finally in step five as aggregate demand shrinks inflationary pressures subside. [MUSIC] Okay, why don't you try to draw your own figure now and illustrate how to use, for example, a change in reserve requirements by the central bank to close a recessionary gap. Of course to answer this question you first have to decide whether the central bank will increase or decrease reserves, so give this one a spin and let's see what you come up with. [MUSIC] This figure shows the answer to the question of how to close your recessionary gap using a change in the reserve requirement. Here we see that a decrease in the reserve requirement, r, leads to an increase in the money supply, m. This increased supply of money in turn leads to a fall in interest rates along with a weakening of the domestic currency. Lower interest rates then directly stimulate the investment driver in the GDP growth equation, while a weaker currency boosts net exports as exports rise and imports fall. The result is an increase in aggregate demand and the desired stimulus. But here's a question that might be bugging you, how much exactly was the economic stimulus? [MUSIC] In fact, you should see right away from our two examples of closing recessionary and inflationary gaps by monetary policy actually lacks the precision of fiscal policy. This is because even though the central bank may be able to determine how much it has changed the money supply with, say an open market operation or a change in the reserve requirement, the central bank still cannot know with any precision exactly how much investment and net exports in the GDP growth equation will respond as the multi-step monetary transmission mechanism unfolds. So given this lack of precision, does that mean that fiscal policy is always better to use than monetary policy? As we will see in our next module the answer to that question is not necessarily. So when you are ready, let's move on to that module and clear this particular question right up. [MUSIC]
