Question

6. The economy is in an inflationary gap.

a) Describe the appropriate monetary policy and the steps the Bank of Canada takes.

b) Draw the AS-AD model, starting in a recessionary gap. Show the effect of the appropriate monetary policy on the diagram. What happens to real GDP, unemployment, and inflation?

c) As a result of the monetary policy, do unemployment and inflation move in the same direction or opposite directions?

Answer 1

a) if the economy is in an inflationary gap then it means that the aggregate demand is more than what is required to sustain the the full employment in the economy. Therefore the appropriate monetary policy would be a Contractionary monetary policy. The steps which the bank of Canada takes are:

• Open Market Sales of Government securities.
• It can increase the bank rate
• Move Federal government deposits from chartered Bank to Bank of Canada

b)

c) as can be seen in the diagram as a result of monetary policy unemployment increases and inflation decreases. Therefore we can see that unemployment and inflation move in the opposite directions as a result of monetary policy.