Answer to Question #239015 in Macroeconomics for Bawa

Question

(a) what are inflationary and deflationary gap? use money and goods market diagrams to illustrate how fiscal policy can be used to close an inflationary gap (b) Suppose that you are the governor of Bank of Ghana. The economy is experiencing a sharp and prolonged inflationary trend. i. What change in (a) open market operations, and (b) required reserve ratio would you consider? ii. Explain in each case how the change you advocate would affect the money market and the goods market. Use appropriate diagrams.

Answer 1

a. Inflationary gap is the difference between the current level of real gross domestic product (GDP) and the GDP that would exist if the economy was operating at full employment.

Deflationary gap is the difference between the full employment level of output and the actual output.

Under monetary policy, money supply is reduced and interest rates are increased. The gap can be reduced by either reducing money income through reduction in government expenditure or by reducing output of goods and services or by increasing taxes.

b.

i) Open market operations. I will recommend sale of government securities by central bank if Ghana. This will reduce money supply and then cause a rise in interest rates which will bring down investment demand and consumption demand. This will cause a decline in aggregate demand and the price will fall thus reducing inflation.

ii) Reserve ratio. To reduce inflation, an increase in reserve ratio will lead to a decrease in the bank's lending power which in turn will reduce the money supply in the economy.