Question

Draw an AS-AD graph showing a recessionary gap labeling carefully. Show how central bank could act to close the gap. Show how this would be accomplished with open market operations on a Supply and Demand for Reserves graphs, starting from a point where there is no discount lending.

Answer 1

A recessionary gap in the economy exist in the current level of output Y* is less than the full employment Yf. This is shown in the figure below where the current equilibrium at point E has lower level of real GDP Y* than full employment level Yf and the recessionary gap is Yf-Y*

Central Bank of the economy can close this recessionary gap by stimulating the aggregate demand. This is done by increasing the money supply in the economy using open market purchase of government securities. In the market for non borrowed reserves this will increase the supply and reduce the federal funds rate. As a result there will be an increase in bank reserves, which therefore increases the lending capacity of the banking system. Interest rates are reduced due to which investment is increased and aggregate demand is increased as well

Finally the aggregate demand curve shifts to the right and this shift closes the recessionary gap because now the new equilibrium GDP is equal to its full employment level