Question

6. Monetary policy and the problem of inflationary and recessionary gaps On the following graph, the economy is producing at point A (grey star symbol), which corresponds to the intersection of the AD, and SRAS curves. The Federal Reserve ("the Fed") is considering whether to intervene in an effort to bring the economy back to its potential. ? LRAS SRAS, 165 160 No Intervention SRAS2 155 150 If Fed Intervenes PRICE LEVEL 145 140 AD2 135 ADA 130 125 10 11 17 18 12 13 14 15 16 REAL GDP (Trillions of dollars)
1. GDP is _____  11 trillion/ 16 trillion/ 10 trillion / 14 trillion /12 trillion

2. currently _____ recessionary gap / inflationary gap

3. of ______ 4 trillion / 1 trillion / 5 trillion / 2 trillion / 3 trillion

4. the Fed will ____ increase / decrease

5. which will _____ increase/ decrease

6. incentive to ____ increase / decrease

7. shifting the ____ AD / SRAS / LRAS

8. curve to the ____ left / right

9. relatively high ___ inflation / unemployment

10. causing relatively high _____ inflation/ employment

Answer 1

In this economy, the Natural Real GDP is $14 trillion.

Natural Real GDP is represented by the LRAS

Since Real GDP is currently $12 trillion (as shown by point A), this level of output means there is currently recessionary gap of $2 trillion.

Recessionary gap occurs when the actual GDP (i.e., at point A) is lower than the Natural Real GDP. Recessionary gap is the difference between Natural real GDP and actual real GDP.

Now suppose the Fed chooses to intervene in an effort to move the economy more quickly back to its potential output. To do so, the Fed will increase the money supply, which will decrease the interest rate, thereby giving firms an incentive to increase investment, shifting the AD curve to the right.

Compare yout answer from the previous few questions. If Fed does not intervene, the economy will likely have reltaively high unemployment. On the other hand, if Fed does intervene, it risks causing relatively high inflation, if its changes the money supply too much.

LRAS SRAS 165 160 SRAS No Intervention 155 150 If Fed Intervenes PRICE LEVEL 145 140 AD 135 AD 130 125 10 17 18 12 13 14 15 16 REAL GDP (Trillions of dollars)