Talona's latest economic data indicates that the growth rate of gross domestic product (GDP) is 0.08 percent and the unemployment rate is 8.1 percent, while Genovia's economic data indicates a continuing upward pressure on price levels. Diagnose the current health of each of these economies, and provide your prescription of the appropriate monetary policy remedy needed in each instance

Answer 1

Talona's economy is suffering from recession and high unemployment, with output below potential GDP. An expansionary monetary policy can help the economy return to its potential GDP. Expansionary monetary policy leads to lower interest rates. As a result, business investment spending and consumer borrowing increase. An increase in aggregate demand causes a rightward shift of the aggregate demand curve, leading to an increase in the price level, output level, and employment.

Genovia's economy is producing at a quantity of output above its potential GDP. A contractionary monetary policy can reduce the inflationary pressures in the economy. Contractionary monetary policy that leads to higher interest rates and a reduced quantity of loanable funds reduces two components of aggregate demand: business investment spending and consumer borrowing. Business investment spending will decline because it is less attractive for firms to borrow money. Even firms that have money will notice that with higher interest rates, it is relatively more attractive to put those funds in a financial investment than to make an investment in physical capital. Higher interest rates will also discourage consumer borrowing for big-ticket items, such as houses and cars. A reduction in aggregate demand causes a leftward shift of the aggregate demand curve, leading to a reduction in the price level, output level, and employment.