IB DP Economics - Unit 3 - Expansionary and contractionary monetary policies to close deflationary/recessionary and inflationary gaps-Study Notes - New Syllabus

Expansionary and Contractionary Monetary Policies to Close Deflationary/Recessionary and Inflationary Gaps

Monetary policy is used by the central bank to influence:

• Aggregate demand (AD)
• Output
• Employment
• Inflation

Through changes in:

• Interest rates
• Money supply
• Credit conditions

the central bank attempts to stabilize the economy and close macroeconomic gaps.

Macroeconomic Equilibrium and Potential Output

Potential output refers to the level of real output produced when resources are fully employed.

This is also called the:

• Full employment level of output
• Long-run equilibrium output

Short-run equilibrium may occur at output levels above or below potential output.

Deflationary/Recessionary Gap

A deflationary gap (or recessionary gap) occurs when:

Actual output < Potential output

The economy operates below full employment.

Characteristics of a Deflationary Gap

• High cyclical unemployment
• Weak aggregate demand
• Low inflation or deflation
• Unused productive capacity
• Low business confidence

Inflationary Gap

An inflationary gap occurs when:

Actual output > Potential output

The economy operates beyond full employment capacity.

Characteristics of an Inflationary Gap

• High inflationary pressure
• Excessive aggregate demand
• Labour shortages
• Strong consumer spending
• Rising wages and production costs

Expansionary Monetary Policy

Expansionary monetary policy is used to increase aggregate demand and close a deflationary/recessionary gap.

The central bank attempts to stimulate economic activity by:

• Increasing money supply
• Reducing interest rates

Main Tools of Expansionary Monetary Policy

• Lowering policy interest rates
• Buying government securities (open market operations)
• Reducing reserve requirements
• Quantitative easing

How Expansionary Monetary Policy Works

Step 1: Interest Rates Fall

The central bank lowers interest rates and increases money supply.

Step 2: Borrowing Increases

Lower interest rates reduce the cost of borrowing.

Households and firms increase:

• Consumption
• Investment

Step 3: Aggregate Demand Increases

Higher consumption and investment increase aggregate demand.

AD shifts right

Step 4: Output and Employment Increase

Firms increase production to meet higher demand.

This leads to:

• Higher real GDP
• Higher employment
• Reduced cyclical unemployment

Closing a Deflationary Gap

Expansionary monetary policy moves the economy closer to potential output.

The recessionary gap decreases as output rises.

Advantages of Expansionary Monetary Policy

• Reduces unemployment
• Stimulates economic growth
• Encourages investment and spending
• Helps avoid prolonged recession

Possible Limitations

• Effects may take time to occur.
• Consumers and firms may still lack confidence during recessions.
• Very low interest rates may create liquidity traps.
• May create inflation if expansion becomes excessive.

Contractionary Monetary Policy

Contractionary monetary policy is used to reduce aggregate demand and close an inflationary gap.

The central bank attempts to slow economic activity by:

• Reducing money supply
• Increasing interest rates

Main Tools of Contractionary Monetary Policy

• Increasing policy interest rates
• Selling government securities
• Increasing reserve requirements
• Reducing liquidity in financial markets

How Contractionary Monetary Policy Works

Step 1: Interest Rates Rise

The central bank raises interest rates and reduces money supply.

Step 2: Borrowing Decreases

Higher interest rates increase the cost of borrowing.

Households and firms reduce:

• Consumption
• Investment

Step 3: Aggregate Demand Falls

Lower spending reduces aggregate demand.

AD shifts left

Step 4: Inflationary Pressure Falls

Reduced aggregate demand lowers pressure on:

• Prices
• Wages
• Production costs

The economy moves closer to potential output.

Closing an Inflationary Gap

Contractionary monetary policy decreases excessive aggregate demand.

This helps stabilize inflation.

Advantages of Contractionary Monetary Policy

• Controls inflation
• Reduces overheating in the economy
• Promotes price stability
• May improve external balance

Possible Limitations

• May reduce economic growth.
• May increase unemployment.
• Higher interest rates may reduce investment.
• Effects may occur slowly.

Comparison Between Expansionary and Contractionary Monetary Policy

Monetary Policy and the Business Cycle

Monetary policy is often used to stabilize fluctuations in the business cycle.

During Recession

• Expansionary monetary policy is used.
• Goal: stimulate AD and reduce unemployment.

During Inflationary Boom

• Contractionary monetary policy is used.
• Goal: reduce inflationary pressure.

Effectiveness of Monetary Policy

The effectiveness of monetary policy depends on:

• Consumer and business confidence
• Strength of the banking system
• Interest rate responsiveness
• Global economic conditions