1. Recessionary and Inflationary Gaps and 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 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

4. 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

5. 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

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 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)

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
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
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
Price Level (P) S1 D S0 F E B
Inflationary
gap
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
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

16. 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

17. 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

18. 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