Question

explain how monetary policy can (under certain conditions) remove an economy from a recessionary gap.

Answer 1

Solution: When the economy is operating at a level below the full empolyment equilibrium we say there is a recessionary gap.It is the difference between the full empolyment GDP and real GDP which is below the full empolyment level.Let us understand this with the help of following diagram :

The difference between L* and L is the recessionary gap .Now let us see how moneytary policy can remove the economy from recessionary gap.For this the government has to pursue expansionary monetary policy.So the AD will shift to right.This increase in AD will increase the output leading to increase in empolyment and hence the GDP of the economy will increase and become equal to potential GDP which is L*.

Hence the equilibrium will be at the point where LRAS =SRAS=AD.