Question

How did market self correct inflationary gap and recessionary gap?

Answer 1

In an inflationary gap the real production is more than the full employment real production. This means that there is a shortage in the resource market and labour is over employed. Due to the shortage of labour in the long run, the wages become higher due to Greater demand for labour. This causes the prices of factors of production to increase and brings about a decline in the short run aggregate supply till it meets the Long run aggregare supply curve. This brings about an automatic correction in the inflationary gap since the real GDP will start declining and hence begin to close the inflationary gap.

In a recessionary gap the real production is lesser than the full employment real production and labour is under employed. This means that there is an over supply of labour. Labour unemployment is high. With the self correction mechanism the recessionary gap is closed in the long run with lower wages and increase in the short term aggregate supply due to lower cost of factors of production. This results in a reduction in the cost of production and the shift in the short run aggregate supply curve to the right till the gap is closed.