Transcript Document

Lesson 7-3
Recessionary and Inflationary Gaps
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.
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.
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.
.
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
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.
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.
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.
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