Question

The economy is in a recessionary 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?

Answer 1

a). To eliminate a recessionary gap a central bank would need to introduce an expansionary monetary policy. An expansionary monetary policy includes ,

• Purchasing of government owned securities- The purchase of government owned securities by the central bank would add more money supply into the economy and there by decrease the interest rate, this inturn induce the aggregate demand. As the aggregate demand increases the real GDP will increase and this helps to eliminate the recessionary gap.
• Decrease in the discount rate - The discount rate is the rate at which the central lends to the commercial banks , a decrease in the discount rate makes the borrowing more cheap for the commercial banks so they would increase their lending and this would induce the investment spending. Since the investment spending is a component of the aggregate demand , the aggregate demand would increase so the real GDP.
• Decrease in the reserve ratio- The commercial banks are required to keep a certain percentage of their deposits as reserves with the central bank so a decrease in the reserve ration would increase the excess reserves held by the commercial banks. The increase in the excess reserves would lead to an increase in the lending so the investment spending and the aggregate demand would increase.

b).

Initially the economy were at the point A with the recessionary gap and with the expansionary monetary policy the government would be able to increase the aggregate demand , so the aggregate demand curve shifts right and closes the recessionary gap. The inflation and the real GDP will increase and the unemployment decreases.