Contrast the actions a central bank should take when an economy is in recession with production substantially below potential gdp and those needed when an economy is producing in overdrive above potential gdp.

Economy in recession: expansive monetary policy.

Economy producing more than its potencial GDP: restrictive monetary policy.

Explanation:

Central bank is in charge of executing monetary policy and exchange rate policy. This means that is in charge of control supply of money (which can be used to modify interest rates), and also is in control of the exchange rate policy (which means control the value of the currency in terms of others currencies by demanding or supplying exchanges currencies when needed). When the economy is in recession, monetary policy (which basically consists on increasing or decreasing money supply), should be expansive: this means that monetary authorities should attempt to lower interest rates by increasing money supply. This will cheapen the cost of investment and will encourage consumption (by making saving unattractive), both components of aggregate demand. This would result in an increase of aggregate demand and, as a consequence an increase in the GDP.On the other hand, when the economy is producing overdrive above potential GDP, monetary policy should be restrictive: this means that monetary policy shoud attempt to increase interest rates, by decreasing money supply. This is because when economy is producing above potential GDP, growth in aggregate demand would yield in higher prices. Then, to avoid an increase on prices, monetary authority should discourage demand. This can be done by increasing interest rates: higher interest rates means less investment (it becames more expensive to invest), and less consumption (it becames more attractive to save money), both components of aggregate demand that are lowered down.

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