Question

Draw and properly label AD-AS graph(s) to show recessionary and inflationary gaps

    (6%). Then, discuss neoclassical perspective to closing recessionary and

    inflationary gaps

Answer 1

AD-AS diagram

note: In the diagram below P is the price and Y is the output(GDP), Ye is the point of optimal employment and when the output falls below Ye to Y1 it creates a recessionary gap and if output(y) grows more than optimal will causes prices to rice creating an inflationary gap between Ye to Y2

According to a theory of a neoclassical economists called Keynesian focused on supply and demand as a driving force for production, pricing and consumption of goods and services. A decrease in aggregate demand(from the diagram, shift of AD2 to AD1) causes the economy to go into recession with high unemployment and an increase in aggregate demand above optimal employement causes inflation. According to him government intervention boosts demand, So there are two policies government uses to close both recessionary and inflationary gaps which are as follows:

1. Fiscal Policy: There are two types of fiscal policies which are: Expansionary and contractionary policies. To stimulate growth and decrease unemployment to overcome the recessionary gap the government will implement the expansionary fiscal policy. Expansionary fiscal policy is implemented by increasesing government spending on investments, transfer payments etc and tax policies are introduced by reducing taxes, which will help in increasing the disposible income of a consumer and investor causng an increase in the consumer spendingand investments which will lead to an increase in the output produced, more employement and the value of output. The contractionary fiscal policy is the vice versa of expansionary, the government increases taxes and reduces spending, to control inflation so the demand and output falls to optimal output at Ye(in the above graph).

2. Monetary Policy: There are both expansionary and contractionary method for monetary policy to control the economy and stimulate growth. Expansionary policy is implemented by increasing the supply of money in the economy. The Central bank is the one who implents monetary policy, Central Bank increases the liquidity by reducing Resrve ratio of banks increasing the borrowing power of banks or or it purchases bonds which will increase the amount of cash in the banks. Increased supply of money will cause the interes rates to fall. So businesses and individuals will borrow more when interest rates fall and invest, increasing the productivity, prices and achieves maximum employement(Ye in the above graph). The contractionary monetary policy is the opposite of this, Central bank implement contractionary monetary policy to combat inflation and it is done by reducing the liquidity or supply of money, Central bank increases reserve ratio which contracts the borrowing power of banks and also sells bonds reducing supply of money.