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
2
Recessionary gap
Real Expenditure
Potential GDP
45°
C+I0+G+(X-IM)
E
B
Recessionary gap
Real GDP
Price Level
6,000 7,000
Potential GDP
S
D0
E
S
B
Recessionary gap
D0
0
6,000 7,000
Real GDP
3
Full Employment Equilibrium
Real Expenditure
Potential GDP
E
45°
C+I1+G+(X-IM)
Real GDP
Price Level
7,000
Potential GDP
D1
S
E
S
D1
0
7,000
Real GDP
4
Inflationary Gap
Potential GDP
45°
Inflationary
gap
gap
C+I +G+(X-IM)
Real Expenditure
B
2
E
Price Level
7,000 8,000
Potential GDP
D2
E
Inflationary B
gap
S
0
Real GDP
S
D2
7,000 8,000
Real GDP
5
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
6
Elimination of Recessionary Gap
Self-Correcting Mechanism
Potential
GDP
S0
Price Level (P)
D
S1
E
100
B
F
S0
S1
Recessionary
gap
D
5,000 6,000
Real GDP (Y)
7
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
8
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
9
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
10
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
11
Elimination of an Inflationary Gap
Self-Correcting Mechanism
Potential
GDP
S1
D
Price Level (P)
F
B
S0
E
Inflationary
gap
S1
D
S0
Real GDP (Y)
12
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
13
Use of Fiscal Policy to Close
Recessionary or Inflationary Gap
Recessionary gap
Real Expenditure
Potential GDP
45°
C+I0+G+(X-IM)
E
B
Recessionary gap
Real GDP
6,000 7,000
Potential GDP
Price Level
What can the
government do
to close the
recessionary
gap?
S
D0
E
S
B
Recessionary gap
D0
0
6,000 7,000
Real GDP
15
Increase G or Reduce T to Close the Recessionary Gap
Potential GDP
45°
Real Expenditure
C+I0+G1+(X-IM)
C+I0+G+(X-IM)
E
B
G1 > G
Recessionary gap
Real GDP
Price Level
6,000 7,000
Potential GDP
S
D0
E
S
B
Recessionary gap
D1
D0
0
6,000 7,000
Real GDP
16
Inflationary Gap
Potential GDP
45°
Inflationary
gap
gap
C+I +G +(X-IM)
Real Expenditure
B
2
2
E
Price Level
7,000 8,000
Potential GDP
D2
E
Inflationary B
gap
S
0
What can the
government do
to close the
inflationary
gap?
Real GDP
S
D2
7,000 8,000
Real GDP
17
Decrease G or Increase T to Close the Recessionary Gap
Real Expenditure
Potential GDP
Inflationary
gap
B
45°
C+I2+G2+(X-IM)
E
Price Level
7,000 8,000
Potential GDP
D2
E
Inflationary B
gap
C+I2+G1+(X-IM)
Real GDP
S
S
D1
0
7,000 8,000
G1 < G2
D2
Real GDP
18