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Recession and tools to stimulate the economy

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U.S. GDP Growth Rate. Retrieved November 15, 2010 from: http://www.tradingeconomics.com/economics/gdp-growth.aspx?Symbol=USD

You have been selected as an advisor to President Obama. How is a recession defined? Is the U.S. currently in a recession? What specific policy tools could be used to stimulate the economy?

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Solution Summary

This solution defines recession and explains whether the United States is in a recession. It includes also what necessary policy tools could be used to stimulate the economy.

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The technical definition of recession is negative growth rate in GDP for two consecutive periods.

Based on the data presented in the article, the US economy is NOT anymore in a recession. Close observation of the graph shows that there are no two consecutive periods where the GDP was negative. In fact all the data have positive growth rates.

Policy Tools to Stimulate the Economy

The Federal Reserve being the central bank for the US banking system is empowered with monetary tools to stimulate the US economy. These tools are:

1. Federal Reserve Open Market Operations

This is the most potent monetary tool available to the Federal Reserve. This involves buying and selling of government securities such as treasury bonds, bills, and notes. The purpose of this tool is to siphon off excess money circulating in the economy.

The effects of this tool to the economy are clearly discussed in the examples below:

For example, if the Fed wants to increase the money supply in a bid to stimulate the economy and encourage spending, the Fed will buy securities from financial institutions. The Fed pays for these transactions by crediting the institution's account at its regional reserve bank. All member banks of the Federal Reserve System must have accounts with the Federal Reserve and mandated minimums must be maintained in the account.

By selling securities to the Federal Reserve, the institution receiving the funds now has a greater surplus of cash. This can be used to provide additional commercial loans or even to lend to other institutions with a temporary cash shortage. Cash shortages may arise from unexpected end-of-day processing that leaves an institution short on its required minimum deposit, which is a common occurrence. Institutions with cash shortages can turn to the overnight market to borrow ...

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