When experiencing a recession caused by decreased aggregate demand what is the best action the Fed could take to close contractionary gap?
In general, the most important tool that the Fed has at its disposal is open market operations. This tool is the most important because it can be used on a day-to-day basis and to make fine adjustments to the money supply. This makes it the most useful in ordinary circumstances.
However, in the case of a recession caused by a drop in aggregate demand, the Fed’s ability to change interest rates can be (depending on what the interest rates are to begin with) the best tool to use. The reason for this is that changes in the interest rate are very high-profile events. When the Fed changes the interest rates, everyone who pays any attention knows about it. By contrast, open market operations are largely unknown to the general public. Therefore, a reduction in interest rates is more likely to catch the attention of consumers. They are more likely to be encouraged by the reduction and, therefore, to start spending more money. Consumer spending is the greatest part of aggregate demand so this is very important.
Therefore, even though open market operations are more important in most cases, decreasing the interest rate is usually the best thing the Fed can do in case of a recession caused by a decline in aggregate demand.