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Assume the central bank decides to move and close the GDP gap instead of fiscal policy....

Assume the central bank decides to move and close the GDP gap instead of fiscal policy.

In what direction will interest rates have to move to close the GDP gap and what type of open market operation will the central bank undertake?

GDP gap (Recessionary and inflationery)

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Answer #1

When there is recessionary gap, interest rate will have to decrease so that investment spending increases and AD increases to close the recessionary gap. Fed will have to undertake open market purchase of government securities to increase the money supply.

When there is inflationary gap, interest rate will have to increase so that investment spending decreases and AD decreases to close the inflationary gap. Fed will have to undertake open market sale of government securities to decrease the money supply.

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