Keynesian Monetary Policy
Keynesian Moneterists believed that monetary policy should be used to close GDP gaps, whether it be a recessionary gap or an expansionary gap. Their goal is to achieve full employment.The down side; if you're trying to close recessionary gap, it means you are fighting unemployment. The philips curve talks about how unemployment impacts inflation.They are inversely related.

Expasionary gap: this is when potential GDP (vertical line) is to the left of actual GDP (the intersection between AS and AD). An expansionary gap means that the economy is in a period of rapid growth where workers are being brought in and we are still producing more then our potential GDP. During an expansionary gap, Keynesian monertary policy says to implement contractionary monetary policy. Contractionary monetary policy is when the Bank of Canada either increases interest rates or reduces the money supply. Increasing interest rates will slow invesment spending causing our overall actual GDP to fall, or at least slow down the growth. A decrease in the money supply will limit the amount of money in circulation meaning banks will not be able to lend money as easily, therefore consumers will not be as able to borrow which will cause a decrease in consumer spending thus lowering actual GDP. After increasing interest rates and lowering the money supply, we should see the economy back at equilibrium.

external image AgMk04b.gif
This graph shows us SRAS (aggregate supply), LRAS (potential GDP) as well as AD (aggregate demand). We see that the green LRAS curve is to the left of the equilibrium point between SRAS and AD. This shows us that there is an inflationary gap, or what we refer to as an expansionary gap. We know that contractionary monetary policy should be implemented to lower AD and close the expansionary gap. (1)
Recessionary Gap: this happens when potential GDP is to the right of our actual GDP. Being in a recessionary gap means, as a country, we are not utilizing all of our resources and functioning at full employment. When a country is experiencing a recessionary gap, Keynesian monetary policy says to implement expansionary monetary policy. Expansionary monetary policy is when the Bank of Canada chooses to lower interest rates and increase the money supply, the opposite of contractionary monetary policy. Now it will effect the economy in reverse. A decrease in interest rates helps stimulate investment spending because the cost of borrowing is lower which will increase actual GDP. An increase in the money supply means that consumers can borrow from banks easier thus stimulating consumption spending and increasing actual GDP. Again, after making changes to the interest rate and money supply, the economy should reach equilibrium.

Recessionary Gap
Recessionary Gap

Like the graph above, we are shown SRAS (aggregate supply), LRAS (potential GDP) and AD (aggregate demand). However, we now see the the green LRAS curve is to the right of the equilibrium point between SRAS and AD. Now we see that there is a recessionary gap, and will need to implement expansionary monetary policy to increase AD to close the gap. (2)

*All typed information taken from lecture notes "Monetary Policy" from slides 33 and 39.*
(1) AmosWeb Encyclonomic. "Inflationary Gap." Accessed April 10, 2012.
(2) AmosWeb Encyclonomic. "Recessionary Gap." Accessed April 10, 2012.