Question

Canada has been experiencing sluggish economic growth recently, so that real GDP is below potential GDP.

• Identify the specific type of output gap that currently exists in Canada.
• Identify ONE specific demand side policy the government could pursue to remedy this output gap.
• Briefly explain how this policy would move the economy to full employment within the context of the AD-AS model.

Answer 1

The Output gap is called Recessionary Gap since, the Actual output Level (Y1) < Potential Level of Output (Y*)

Government may increase its spending to close the recessionary gap

Initial equilibrium occurs at point E where SRAS and AD curve intersects. Economy experiences recessionary gap equivalent to the distance between Y1 and Y*

The government adopts Expansionary Fiscal policy through which it increases the spending on infrastructure. THis infuses extra money into the economy and raises the purchasing power of the public. People will start spending more on goods and services. The AD curve shifts right from AD to AD1. New equilibrium occurs at point E1 with price level P2 and output = Full potential level of output. Recessionary gap is closed at this point.

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