Question

Use one of the traditional monetary policy tools to explain how monetary policy may be used by the Federeal Open Market Committee to close recessionary and inflationary gaps by changing money supply, interest rates, investment and gross domestic product (GDP) . You must use two graphs of money supply-demand, investments and GDP to illustrate your explanations

Answer 1

Exansionary monetary policy is used to bring economy back from recession.

To increases liquidity

1. Interest rates are reduced

2. Reserve requirements are reduced

3. Buying of bonds in open market operations

Exactly opposite happens in contractionary monetary policy.

Contractionary monetary policy is used to control inflation i.e. price stability.

If expansionary monetary policy then investments are expected to increase, so AD moves rightwards.

If contractionary monetary policy then investments are expected to decrease, so AD moves leftwards.

Below graph shows inflationary gap.

Central bank uses contractionary fiscal policy for price stability.

Below graph shows recessionary gap.

Central bank uses expansionary monetary policy to bring back economy from recession.