Question

Explain a recessionary gap (or deflationary gap) and an inflationary gap. What are the classical solutions to recessionary and inflationary gaps? What are the Keynesian solutions to recessionary and inflationary gaps?

Answer 1

Ans. In macroeconomics, a recessionary gap occurs when an economy operates at a level below the full-employment equilibrium. Whereas, an inflationary gap occurs in an economy when the economy's GDP is above the potential full-employment GDP.

According to the classical theory, in a recessionary gap there are widespread market surpluses in the form of unemployed workers, unsold goods, etc. Firms and workers react to these market surpluses by lowering their prices and wages. In an inflationary gap there are widespread shortages of workers and resources and firms and workers raise the prices in order to deal with the inflationary gap.

Keynesians believe that the solution to a recessionary gap is the expansionary fiscal policy in the form of tax cuts to stimulate the consumption and investment or increases in government spending. Either of the two would shift the aggregate demand curve to the right. In the case of an inflationary gap, the Keynesians suggest contractionary fiscal policy in the form of decrease in government spending or tax increases to shift the aggregate demand to the left.