Question

Suppose the following table illustrates the values of real and potential GDP if the Reserve Bank of Australia (RBA) does not change its current monetary policy to be more contractionary or expansionary.

year	potential GDP	real GDP	price level
2016	$1.42 trillion	$1.42 trillion	114
2017	$1.48 trillion	$1.46 trillion	116

c) Suppose that the RBA uses an appropriate policy and is successful in keeping real GDP at potential in 2017. Discuss the type of monetary policy that the RBA should adopt, explaining the effect of the policy on real GDP, the price level and employment. Use a dynamic aggregate demand and supply model to illustrate your answer.

Answer 1

Here real GDP level is less than potential level. There is scope to increase aggregate output and employment level. Hence, Central bank must use expansionary monetary policy to increase real output level. But increase in aggregate demand partially get reflected in price level and partially in real GDP.

Central bank will reduce federal fund rate and will buy securities from open market. Such steps would reduce interest rate, and aggregate demand shall rise up.

Following is diagram:

In above diagram, aggregate demand (AD) shifts to right thereby increasing both output and average price level.