Question

Suppose real GDP is $2,500 trillion while potential GDP is $1,000 trillion. What open market operation could the central bank use to close the gap? How much would this need to be if the reserve requirement was 20%?

Answer 1

Check the explanation

Step-by-step explanation:

The inflationary gap will be = Real GDP - Potential GDP, which will give you = $2,500 - $1,000 = $1,500.

The Federal government will have to lessen the actual GDP so as to close the gap since the actual GDP is bigger than the potential GDP. In this case, the Federal government will have to lower supply of money. So that it would have to sell securities to the banks. When the Federal government sells securities companies and private individuals, money is expected to flow from the banking system to the Federal government.

Here, multiplier = 1/reserve ratio = 1/20% = 1/0.20 = 5

So, in closing the space and lowering GDP by $1,500 trillion, the Federal government will have to sell securities worth $1,500 trillion/5 = $300 trillion.