Question

Figure: North-West Economy

North-West economy LRAS SRAS AD Y1 YE Real GDP potential output

a) Is North-West facing a recessionary or expansionary gap? Justify your answer.

b) If you are the chair of the Central Bank of this country, which type of monetary policy, expansionary or contractionary, would you adapt to fix the economy of North-West? Give examples, explain and be detailed.

c) If you are the President of this country, how would you use Fiscal policy to fix the economy of North-West? Give examples, explain and be detailed.

Answer 1

A. An economy faces recessionary gap when its real GDP is below its potential level of output.

Here, north west is facing recessionary gap.

B. An expansionary monetary policy should be introduced. That will result in outward and right shift in AS. This will lead to new equilibrium with real gdp equal to potential level of output.

C, expansionary fiscal policy should be used. It will shift AD curve to the right. New equilibrium will be achieved at new AD curve and old AS curve. This will cover the recessionary gap and potential level of output will be achieved.