Question

In the case where policy makers which to return the economy to Y*, can this objective be accomplished using monetary policy? Support your answer.

Answer 1

We know that Y represents actual GDP or actual output and Y* represents potential GDP or potential output. There can be two conditions where there are economic functions in the economy and both arise when either Y>Y* or Y<Y*.

1. Inflationary gap - Y>Y* (Actual GDP is greater than potential GDP)

This means the actual output level exceeds the potential output level of the country. There can be various reasons involved in this like more money in the hands of people which gives rise to an increase in aggregate demand in the economy. When aggregate demand increases so much that it surpasses the production capacity and the supply cannot fulfill the demand, there is an overall rise in prices in the economy.

To return the economy to Y* (potential output level), policymakers need to use contractionary monetary policy. Under this the money supply is decreased in the economy by increasing the interest rates. When interest rates increase, investments will decrease as it will become costly for the lenders to borrow money and savers will deposit more money in order to get the advantage of higher interest rates which will lead to a decrease in money supply in the economy. Since investment demand and consumption demand both decrease, it will lead to a fall in prices and the actual output will become equal to the potential output.

2. Recessionary gap - Y<Y* (Actual output is less than potential output)

This means the actual output level is less than the potential output level. There can various reasons for this, like low consumption and investment level in the economy due to either higher prices or less money in the hands of people, which further leads to low output levels in the economy. This leads to a fall in aggregate demand curve and the output level falls too.

To return the economy to the potential output level (Y*), policymakers use expansionary monetary policy. Under this, the money supply in the economy is increased by decreasing the interest rates. A fall in interest rates will lead to an increase in investments (as investors will find it profitable to lend money at lower interest rates). This will give a boost to the economy by increasing the production level that further increases the aggregate demand. Thus it helps in bringing the economy back to the potential output level.