Question

Explain the difference between a recessionary and inflationary gap and list and explain at least two things which can be done to offset each. ( Explain at least two things which can be done to close the recessionary gap and two things to close the inflationary gap).

Answer 1

A recessionary gap is caused by a fall in aggregate demand so that real GDP falls lower than potential GDP level. In this situation, price level falls. A recessionary gap can be closed by increasing aggregate demand, by

- Expansionary fiscal policy, by increasing government spending and/or decreasing taxes, and/or

- Expansionary monetary policy, by increasing money supply with open market purchase of government securities, and/or lowering required reserves ratio and/or by raising discount rate.

In contrast, an inflationary gap exists due to an increase in aggregate demand so that real GDP becomes higher than potential GDP level. In this situation, price level rises. An inflationary gap can be closed by decreasing aggregate demand, by

- Contractionary fiscal policy, by decreasing government spending and/or increasing taxes, and/or

- Contractionary monetary policy, by decreasing money supply with open market sale of government securities, and/or increasing required reserves ratio and/or by increasing discount rate.