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Recessionary and Inflationary Gaps and Fiscal Policy. Recessionary and Inflationary Gaps. Recessionary gap Amount by which equilibrium real GDP falls short of the full-employment level of GDP Aggregate demand is weak Inflationary gap
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Recessionary and Inflationary Gaps • Recessionary gap • Amount by which equilibrium real GDP falls short of the full-employment level of GDP • Aggregate demand is weak • Inflationary gap • Amount by which the equilibrium level of real GDP exceeds full employment potential GDP • Excess aggregate demand
Recessionary gap E E B B Potential GDP 45° S C+I0+G+(X-IM) Recessionary gap Potential GDP Recessionary gap Real Expenditure Price Level D0 D0 S Real GDP Real GDP 0 7,000 7,000 6,000 6,000
Full Employment Equilibrium E E Potential GDP 45° S C+I1+G+(X-IM) Potential GDP Real Expenditure Price Level D1 D1 S Real GDP Real GDP 0 7,000 7,000
Inflationary Gapgap Inflationary gap E B B Inflationary gap C+I2+G+(X-IM) Potential GDP E 45° S Potential GDP Real Expenditure Price Level D2 D2 S Real GDP Real GDP 0 7,000 7,000 8,000 8,000
Adjusting to a Recessionary Gap • Deflation or Unemployment? • Recessionary gap • Equilibrium below potential GDP • Cyclical unemployment • Wages may fall • Aggregate supply – shift to the right • Increase GDP to Potential GDP • Prices decline • Self Correcting mechanism
Elimination of Recessionary GapSelf-Correcting Mechanism Potential GDP S1 S0 E B F D Recessionary gap Price Level (P) 100 D S0 S1 6,000 5,000 Real GDP (Y)
Adjusting to a Recessionary Gap • Reasons nominal wages and prices won’t fall (easily) • Institutional factors • Psychological resistance to wage reduction • Business cycles – less severe • Firms – don’t want to lose best employees • Economy gets stuck • Recessionary gap - long period
Adjusting to a Recessionary Gap • Self-correcting mechanism • Workers need jobs - willing to cut wages • Firms – willing to cut prices • Economy’s self-correcting mechanism • The way money wages react to either a recessionary gap or an inflationary gap • Wage changes shift the aggregate supply curve • Change equilibrium GDP and the equilibrium price level
Adjusting to an Inflationary Gap • Inflationary gap • Aggregate demand is exceptionally high • Short-run equilibrium above full employment • Tight labor market • Rising nominal wages • Increase business costs • Prices increase • Self-Correcting Mechanism
Adjusting to an Inflationary Gap • Inflation • Higher prices cut into consumer purchasing power and net exports • Inflationary gap begins to close • Output falls and prices continue to rise • Long-run equilibrium • Higher price level • GDP equal to potential GDP
Elimination of an Inflationary Gap Self-Correcting Mechanism Potential GDP S0 S1 F E B D Inflationary gap Price Level (P) D S0 S1 Real GDP (Y)
Adjusting to an Inflationary Gap • Self-correcting mechanism • Tends to eliminate either unemployment of inflation • Works slowly and unevenly • Not always reliable • Stagflation • Inflation that occurs while the economy is growing slowly or having a recession • Normal after excessive aggregate demand
Use of Fiscal Policy to Close Recessionary or Inflationary Gap
Recessionary gap What can the government do to close the recessionary gap? E E B B Potential GDP 45° S C+I0+G+(X-IM) Recessionary gap Potential GDP Recessionary gap Real Expenditure Price Level D0 D0 S Real GDP Real GDP 0 7,000 7,000 6,000 6,000
Increase G or Reduce T to Close the Recessionary Gap C+I0+G1+(X-IM) G1 > G E E B B Potential GDP 45° S C+I0+G+(X-IM) Recessionary gap Potential GDP Recessionary gap Real Expenditure Price Level D0 D0 D1 S Real GDP Real GDP 0 7,000 7,000 6,000 6,000
Inflationary Gapgap What can the government do to close the inflationary gap? Inflationary gap E B B Inflationary gap C+I2+G2+(X-IM) Potential GDP E 45° S Potential GDP Real Expenditure Price Level D2 D2 S Real GDP Real GDP 0 7,000 7,000 8,000 8,000
Decrease G or Increase T to Close the Recessionary Gap G1 < G2 C+I2+G1+(X-IM) Inflationary gap E B B C+I2+G2+(X-IM) Inflationary gap Potential GDP E 45° S Potential GDP Real Expenditure Price Level D2 D2 S Real GDP Real GDP D1 0 7,000 7,000 8,000 8,000