An economy is facing the recessionary gap shown in the accompanying
diagram. To eliminate the gap, should the central
bank use expansionary or contractionary monetary policy?
How will the interest rate, investment spending, consumer
spending, real GDP, and the aggregate price level change as
the monetary policy closes the recessionary gap?
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To determine whether the central bank should use expansionary or contractionary monetary policy to close the recessionary gap, we need to understand the effects of these policies on the economy.
Expansionary monetary policy is implemented when the central bank increases the money supply and lowers interest rates. This helps stimulate economic activity by making borrowing cheaper, encouraging investment and consumer spending.
Contractionary monetary policy, on the other hand, is implemented when the central bank decreases the money supply and raises interest rates. This aims to reduce inflationary pressures by making borrowing more expensive, thereby slowing down investment and consumer spending.
In the case of a recessionary gap, where the current level of real GDP is below potential GDP, expansionary monetary policy is generally recommended. By increasing the money supply and lowering interest rates, the central bank can encourage borrowing, investment, and consumer spending, thus boosting economic activity and closing the gap.
As the central bank implements expansionary monetary policy and closes the recessionary gap, the following changes can be expected:
1. Interest Rate: The interest rate will decrease as the central bank increases the money supply and lowers interest rates. This will make borrowing cheaper, incentivizing businesses and individuals to take loans and make investments.
2. Investment Spending: With lower interest rates, businesses will be more inclined to borrow and invest in new projects or expand existing ones. This increase in investment spending will contribute to closing the recessionary gap.
3. Consumer Spending: As interest rates decrease, consumers will also be more likely to borrow for major purchases, such as houses or cars. This increase in consumer spending will further stimulate the economy.
4. Real GDP: Through increased investment and consumer spending, the real GDP will start to rise, moving closer to the potential GDP. The expansionary monetary policy aims to close the recessionary gap by boosting economic activity and increasing production.
5. Aggregate Price Level: Initially, the increase in real GDP may result in a slight rise in prices as demand increases. However, if the central bank closely monitors inflationary pressures, the aggregate price level can be controlled to ensure that it does not rise significantly. The central bank can use other tools, like open market operations and reserve requirements, to manage inflation.
In summary, to eliminate the recessionary gap, the central bank should use expansionary monetary policy. This will result in lower interest rates, increased investment and consumer spending, a rise in real GDP, and controlled increases in aggregate price level.