A - If the central bank decides to close the GDP gap the interest rates will fall in the economy. The type of open market operation that the central bank will undertake is buying the government securities.

To close the GDP gap, it is important for the central bank to stimulate economic production. The central bank can stimulate economic production by lowering interest rates. Lowering the interest rates will make the cost of borrowing to decrease, thereby encouraging households and businesses to increase their borrowings. They will use the borrowed money to increase their consumption and investment expenditures. This will lead to increased production in the economy that will close the GDP gap.

The type of open market operation (OMO) that the central bank will pursue to lower the interest rates is buying of the government securities. When the central bank buys the government securities it will increase the money supply in the economy, and this will lead to increased consumption and investment spending in the economy.Increased consumption and investment will lead to an increase in the aggregate demand and aggregate supply in the economy, a factor that will lead to an increase in the GDP.

Question - Using the exchange rate market model, illustrate and explain how the monetary policy action identified in A may affect the exchange rate. Identify the new equilibrium on the diagram as point B.