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Assume the central bank decides to move and close the GDP gap (inflationary and recessionary )instead...

Assume the central bank decides to move and close the GDP gap (inflationary and recessionary )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?

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Answer #1

Recessionary gap: in this case actual GDP is less than full employment GDP. if central bank decides to close the gap it has to enter the open market and purchase government securities. This will decrease the rate of interest in the system and investment will increase. As a result aggregate demand increases and real GDP will increase so much so that the gap is eliminated.

Inflationary gap: in this case actual GDP is more than full employment GDP. if central bank decides to close the gap it has to enter the open market and sell government securities. This will increase the rate of interest in the system and investment will decrease. As a result aggregate demand decreases and real GDP will decrease so much so that the gap is eliminated.

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