A review of the economic performance of Canadian economy by economists at the Bank of Canada...

A review of the economic performance of Canadian economy by economists at the Bank of Canada suggests that the economy has an inflationary output gap.

Explain how the Bank of Canada could use monetary policy instruments to close the inflationary output gap. Explain the process (mechanism) through which this occurs.

Expert Solution

Inflationary Gap in the Canadian Economy suggests that the actual level of output produced by all industries is actually greater than the potential or desired level of output in the long run. So, the Canadian economy is producing more than what is desired and causing the underutilization of scarce and limited resources.

Several policies like Fiscal or Monetary policies could come to rescue and help in closing this gap. Below diagram shows the situation of Inflationary Gap in Canadian Economy and how the Bank of Canada can use monetary policy to combat the situation:

LRAS is the vertical long run supply curve showing the potential or desired level of output, Yp. In short run, the AD and SRAS curves intersect each other at point E. At this point, the output level is Y1. Clearly, the Canadian economy has produced more than what was desired. The distance Yp - Y1 denotes the inflationary output gap.

Use of Monetary Policy:

Bank of Canada as a Central Bank can reduce the flow of money into the economy. This is known as Contractionary Monetary Policy. This will reduce the amount of money in the hands of the public which they use for their daily consumption. As a result, their consumption will reduce and they will start demanding less amount of goods and services. As a result, the Aggregate Demand will fall. AD will shift left from AD to AD1. The Central Bank continues to reduce the money supply till the economy reaches at point E1 in the long run. At this point, LRAS, SRAS and AD1 interesect each other and the economy is now producing the desired level of output. The earlier inflationary output gap of Y1 - Yp is now closed.

So, Money Supply decreases ----> Aggregate Demand will fall -----> Actual output will fall -----> Inflationary gap is closed

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Rahul Sunny answered 6 months ago

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