Stabilizing the economy: the Role of Monetary Policy - How central banks can fight a recession
4 important questions on Stabilizing the economy: the Role of Monetary Policy - How central banks can fight a recession
The effect of using monetary policy to close a recessionary gap is:
The economist John Taylor has proposed a 'rule' which attempts to describe the way in which central banks react to output gaps and inflation:
According to this rule, the central bank responds to both output helps and deviations in the rate of inflation from its targeted level. The coefficients b and c describe the strength of these responses.
Effectiveness of monetary policy in closing output gaps will depend on two factors:
- The interest rate elasticity of the demand for money: the lower the interest rate elasticity of the demand for money, the greater the interest rate decline and the greater the effectiveness of a given monetary expansion in closing a recessionary gap.
- the responsiveness of PAE to changes in the rate of interest: monetary policy will be most effective the consumption and investment are responsive to interest rate changes (when IS curve is relatively flat).
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