Contrast the actions the central bank of a country should take when an economy is in recession with production substantially below its potential gross domestic product (GDP) and those needed when an economy is producing in overdrive above potential GDP

Answer 1

If the economy is in a recession with production substantially below potential GDP, then the central bank should raise the supply of money and credit in the economy. It can do so by first reducing interest rates and, then, by considering the use of quantitative easing and direct loans. Expansionary monetary policy increases the money supply in the economy, which reduces interest rates. The lower interest rates stimulate additional borrowing for investment spending and consumption, causing the aggregate demand curve to shift to the right. This eliminates the recessionary gap and returns the economy to the long-run equilibrium.
If the economy is producing in overdrive above its potential GDP and experiencing high inflation, then the central bank should raise interest rates by reducing money supply. Contractionary monetary policy that leads to higher interest rates and a reduced quantity of loanable funds will reduce aggregate demand. The higher interest rate discourages additional borrowing for investment spending and consumption, causing the aggregate demand curve to shift to the left. This results in lower levels of output and employment.