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In: Economics

how fiscal policy such as changing government expenditure may close recessionary gap/ inflationary gap.

how fiscal policy such as changing government expenditure may close recessionary gap/ inflationary gap.

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Expert Solution

An inflationary gap is a macroeconomic concept that describes the difference between the current level of real gross domestic product (GDP) and the anticipated GDP that would be experienced if an economy is at full employment. This is also referred to as the potential GDP. A recessionary gap is a macroeconomic term which describes an economy operating at a level below its full-employment equilibrium. Under a recessionary gap condition, the level of real gross domestic product (GDP) is lower than the level of full employment, which puts downward pressure on prices in the long run.

A government may choose to use fiscal policy to help reduce an inflationary gap/recession gap, often through decreasing the number of funds circulating within the economy. This can be accomplished through reductions in government spending, tax increases, bond and securities issues, interest rate increases and transfer payment reductions.

These adjustments to the fiscal conditions within the economy can help restore economic equilibrium. By shifting the overall demand for goods, the adjustments control the amount of funds available to consumers. As the amount of money within an economy decreases, the overall demand for goods and services also declines.

For example, if the Federal Reserve raised interest rates in response to inflationary activity, the increase would make borrowing funds more expensive. The increase in the associated expense lowers the number of funds available to most consumers resulting in lowered demand. Once equilibrium is reached, the Federal Reserve can shift interest rates accordingly.


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