 When real output falls short of its potential level, a recessionary gap is created  To stimulate output and increase employment, the Bank of Canada can use an expansionary monetary policy  aka. “easy money policy”  A policy that increases the money supply and reduces interest rates to stimulate the economy Monetary Policy

 In the 2008 financial crisis, many banks in the United States and Europe collapsed, but not those in Canada  The most important reason for this was because Canadian banks engaged in far less risky behaviour  e.g. approving a mortgage based on collateral Why Didn’t Canada’s Banks Collapse Like in the Rest of the World?

 When the economy is in a recession, the Bank of Canada can increase the supply of money, shifting from S to S’  This results in a decreased interest rate Expansionary Monetary Policy QUANTITY OF MONEY ($ billions) INTEREST RATE (%)

 Due to reduced interest and increase in money supply, the economy increases in aggregate demand from AD 1 to AD 2  Both the output and price level rise to give a new equilibrium point, where AD 2 meets AS  Due to a higher potential output level, the recessionary gap is eliminated Expansionary Monetary Policy cont’d Recessionary Gap

 Conversely, in an economic boom, the Bank of Canada can inhibit spending with contractionary monetary policy  aka. “tight money policy” Contractionary Monetary Policy QUANTITY OF MONEY ($ billions) INTEREST RATE (%)  When the bank decreases the money supply, the curve shifts left, from S to S’  Interest rate goes up

Contractionary Monetary Policy cont’d  Economy as a whole decreases in aggregate demand  Price level and output level fall to give a new equilibrium point where D meets S’  Inflationary gap is eliminated  Move these to a new slide lnflationary Gap