Question

5. Draw an AD-AS diagram for an economy which is facing a recessionary gap.

a) To eliminate the gap, should the central bank use expansionary or contractionary

monetary policy?

b) Explain how the interest rate, investment spending, consumer spending, real GDP, and

the aggregate price level will change as monetary policy closes the recessionary gap.

C) Draw an AD-AS diagram for an economy which is facing an inflationary gap.

D)To eliminate the gap, should the central bank use expansionary or contractionary

monetary policy?

b) Explain how the monetary policy you suggest will close the inflationary gap.

Answer 1

We know that the intersection between aggregate demand and supply shows the equilibrium in the economy. The economy’s price level and real GDP are determined in the economy is based on aggregate demand and supply. Suppose that the employment is below the natural rate of unemployment, then real GDP is below the potential rate. So, the aggregate demand and the short-run aggregate supply curve will the left of the long-run aggregate supply curve. The following diagram shows the recessionary gap in the economy:

In the diagram, the lower level of employment produces the lower level of output. The aggregate demand curve and the aggregate supply curve intersects at the left of the long run aggregate supply curve. The gap between real GDP and the potential output, or real GDP less than potential output is called recessionary gap.

A)

Expansionary monetary policy

B)

The expansionary monetary policy will generally close the recessionary gap. For closing the recessionary gap the fed uses the open market operation to buy bonds from the public. It will increase the money supply in the economy. It also increases the bond prices by reducing the rate of interest. The greater the money supply in the economy will lead to falling in the rate of interest and it stimulates investment in the economy. On this way, the recessionary gap will close.

C)

The wage rate is less than the equilibrium wage rate then the employment will exceed the natural rate. So the gap between real GDP and potential output, or real GDP is greater than the potential GDP is called inflationary gap. The following diagram shows the inflationary gap n the economy:

D)

Generally, the contractionary monetary policy closes the inflationary gap in the economy.

E)

The inflationary situation, the fed sells the bond to the open market then the supply curve shifts to the right and it lowers the price of bonds and increases the rate of interest. The higher the rate of interest it decreases the level of investment in the economy.