Lesson 7-3 Recessionary and Inflationary Gaps

1. Lesson 7-3 Recessionary and Inflationary Gaps

2. Recessionary and Inflationary Gaps At any point in time, real GDP and the price level are determined by the intersection of the aggregate demand and short-run aggregate supply curves. The gap between the level of real GDP and potential output when real GDP is less than potential is called a recessionary gap. The recessionary gap appears graphically when the intersection of aggregate demand and short-run aggregate supply occurs to the left of potential output.

3. The gap between the level of real GDP and potential output when real GDP is greater than potential GDP is called an inflationary gap. The inflationary gap appears graphically when the intersection of aggregate demand and short-run aggregate supply occurs to the right of potential output.

4. Restoring Long-Run Macroeconomic Equilibrium A Shift in Aggregate Demand: An Increase in Government Purchases Given an initial equilibrium when G goes up, the aggregate demand curve shifts to the right causing an inflationary gap. The higher price level combined with the fixed nominal wage reduces real wages, thereby encouraging firms to hire extra workers to expand production. Because actual GDP is larger than potential GDP, there is pressure on nominal wages to rise. .

5. As nominal wages rise, the short-run aggregate supply curve shifts to the left reducing real GDP and closing the inflationary gap. Eventually these movements send the economy to potential output and natural employment with a higher price level than initially. A Shift in Short-Run Aggregate Supply: An Increase in the Cost of Health Care Starting from an initial equilibrium position, these health care cost increases shift the short-run aggregate supply to the left generating a recessionary gap. The lower price level combined with a fixed nominal wage causes the real wage to rise, thereby encouraging firms to reduce employment and output

6. Because actual GDP is less than potential GDP, there is pressure for nominal wages to fall. As nominal wages fall, the short-run aggregate supply shifts to the right eventually closing the recessionary gap. Eventually these movements send the economy to potential output and natural employment with a lower price level than initially. The time it takes to restore the economy to potential output depends upon how sticky wages and prices are.

7. Gaps and Public Policy Nonintervention or Expansionary Policy? A policy choice to take no action to try to close a recessionary or an inflationary gap but to allow the economy to adjust on its own to its potential output is a nonintervention policy. A policy in which the public sector acts to move the economy to its potential output is called a stabilization policy. A stabilization policy designed to increase real GDP is an expansionary policy. A contractionary policy is used to correct an inflationary gap.

8. Expansionary policy is designed to correct a recessionary gap. Nonintervention or Contractionary Policy? A stabilization policy that reduces the level of GDP is a contractionary policy. Fiscal policy is the use of government purchases, transfer payments, and taxes to influence the level of economic activity. Monetary policy is the use of central bank policies to influence the level of economic activity.

9. To Intervene or Not to Intervene: An Introduction to the Controversy Advocates for stabilization policies argue that the time it takes the economy to self-correct is too long and causes too many people a lot of suffering to use non-intervention. Advocates for nonintervention agree that stabilization policies can shift the aggregate demand curve but they argue that it takes a very long time to accomplish it, making the impact of the policy unpredictable. Some advocates for nonintervention question how sticky prices really are and whether gaps really