Question

Illustrate and explain how an economy that is at short-run equilibrium can still experience a recessionary gap based on the Keynesian Model. Make sure you label your diagram appropriately

Answer 1

In the cross diagram of Keynesian, when the line of aggregate expenditure intersects the line of 45- the degree at the potential level of Gross Domestic Product (GDP), then the shape of an economy is sound. In this case in the economy no recession, and the natural rate of unemployment (full employment). But there is no assurance that the equilibrium point will occur at the potential level of GDP output. The equilibrium may be higher or lower. The Figure illustrates a situation or a condition the line of aggregate expenditure intersects the line of 45- degree at point Eo, where the real GDP of $ 6000 and which is less than the potential GDP of $ 7000. In this condition or a situation the aggregate expenditure level is too below or low for GDP to attain its level of full employment and will occur unemployment. The Recessionary gap in the figure is where the distance between the Eo output level that is below the potential GDP and the level of potential GDP. This is because the real GDP level of equilibrium is very low, where the firm will not afford to hire the full employment number of workers, and the rate of unemployment will be high. A Recessionary gap is anything that shifts the aggregate expenditure line down is a potential reason for recession, involving a consumption decline, savings increase, decreases in an investment, spending of government drop and rate of taxes high, fall in export, or a rise in import. However, an economy is at equilibrium with a gap of recessionary may just stop there and face an issue or suffer a high level of unemployment for a long duration. The meaning of equilibrium there is no specific adjustment of quantities or prices in the economy to chase away the recession. The response of Keynesian to a recessionary gap is for the government to reduce the tax rate or raise the spending so that the aggregate expenditure shifts from AEo to AE1. Due to this shift occurs, the new equilibrium E1, now the growth of potential GDP growth shown in the figure.

If the equilibrium occurs at an output below potential GDP, then a recessionary gap exists. The policy solution to a recession gap is to shifts the aggregate expenditure schedule up from AEo To AE1, using policies like deduct tax rate or increases the spending of government. Then the new E1 occurs at potential GDP.