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Recessionary and Inflationary Gaps and Fiscal Policy

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 and Fiscal Policy

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  1. Recessionary and Inflationary Gapsand Fiscal Policy

  2. 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

  3. 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

  4. 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

  5. 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

  6. 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

  7. 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)

  8. 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

  9. 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

  10. 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

  11. 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

  12. 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)

  13. 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

  14. Use of Fiscal Policy to Close Recessionary or Inflationary Gap

  15. 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

  16. 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

  17. 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

  18. 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

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