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As an economy recovers from a recession, what policies would a central bank undertake if it...

As an economy recovers from a recession, what policies would a central bank undertake if it is more "dovish"? What are the benefits of these policies? What are the drawbacks? (Use the AS/AD model)

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Expert Solution

Answer - As the dovish view of the central bank suggests , the economy has recovered from the recession , interest rates are very low in the economy and the economy is in the inflationary phase. Now , the fed will have to formulate the contractionary monetary policies in order to protect the economy from overheating.

This will reduce the money supply in the economy , bring back the lost purchasing power of the money in the economy , and bring the economy back to potential level thus , stabalising the economy. Here, due to fall in the money supply , AD will reduce and hence the price level will drop down and also the real GDP will increase to reach the potential level.

But , this has disadvabtages too. The reduction in money supply will lead to rise in interest rates leading to fall in investment. This will lead to increase in rate of unemployment in the economy. The growth of the economy will slow down and income level of people will drop.

Rahul Sunny answered 2 years ago
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