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 Amount by which the equilibrium level of real GDP exceeds full employment potential GDP Excess aggregate demand

Recessionary gap Potential GDP 45° Real Expenditure C+I0+G+(X-IM) E B 7,000 Potential GDP Real Expenditure C+I0+G+(X-IM) E B 6,000 Recessionary gap Real GDP 7,000 Potential GDP Price Level S D0 E B Recessionary gap 6,000 Real GDP

Full Employment Equilibrium 7,000 Potential GDP 45° Real Expenditure C+I1+G+(X-IM) E Real GDP 7,000 Potential GDP Price Level S D1 E Real GDP

Inflationary Gap gap Potential GDP 45° Inflationary gap C+I2+G+(X-IM) 7,000 Potential GDP Real Expenditure Inflationary gap C+I2+G+(X-IM) B E 8,000 Real GDP 7,000 Potential GDP Price Level D2 E S Inflationary gap B 8,000 Real GDP

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 Gap Self-Correcting Mechanism 6,000 Potential GDP Price Level (P) S0 D S1 E 100 B 5,000 Recessionary gap F 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 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 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 Price Level (P) S1 D S0 F E B Inflationary gap 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 45° 7,000 Potential GDP Real Expenditure What can the government do to close the recessionary gap? C+I0+G+(X-IM) E B 6,000 Recessionary gap Real GDP 7,000 Potential GDP Price Level S D0 E B Recessionary gap 6,000 Real GDP

Increase G or Reduce T to Close the Recessionary Gap 45° 7,000 Potential GDP Real Expenditure C+I0+G1+(X-IM) C+I0+G+(X-IM) G1 > G E B 6,000 Recessionary gap Real GDP 7,000 Potential GDP Price Level S D0 E B Recessionary gap 6,000 D1 Real GDP

Inflationary Gap gap 45° 7,000 Potential GDP Real Expenditure Inflationary gap C+I2+G2+(X-IM) B What can the government do to close the inflationary gap? E 8,000 Real GDP 7,000 Potential GDP Price Level D2 E S Inflationary gap B 8,000 Real GDP

Decrease G or Increase T to Close the Recessionary Gap 45° 7,000 Potential GDP Real Expenditure Inflationary gap C+I2+G2+(X-IM) G1 < G2 B E 8,000 C+I2+G1+(X-IM) Real GDP 7,000 Potential GDP Price Level D2 E S Inflationary gap B 8,000 D1 Real GDP