Question

a) Graph Canada beginning in a recessionary output gap.

b) What direction of pressure we have on the following economic variables, given the above output gap.

Wages___________ Unemployment __________ Inflation __________

c) Given the mandate of the Bank of Canada. What actions would we expect the central bank to take?

d) Briefly explain how these actions will be transmitted to affect our economy via the AD-AS

Answer 1

The above image shows the Canadian economy in a recessionary output gap where the real GDP of the economy is less than the potential GDP of the economy.

To fix this, the Canadian economy would increase wages to create more employment and this would lead to a rise in prices to increase inflation.

The bank of Canada, like any central bank in this situation would like to increase the Aggregate Demand in the economy. This would be done by decreasing interest rates so that people have more money to spend on goods which now cost more than they did before.

These actions would induce the Aggregate Demand and Aggregate Supply in the economy to rise. The AD and AS will continue to rise till they reach the desired state where the economy has reached its potential GDP. At that point, the central bank would take measures to maintain the inflation rate. This is shown in the below image.

Note that in the below image only AD increases which might not always be the case. Both AD and AS may also rise leading to the same level of potential GDP.