Question

Draw a diagram with an aggregate demand curve, a short-run aggregate supply curve, and a long-run aggregate supply curve, for an economy facing a recessionary gap. a) If the government does not intervene to close this gap, describe what will happen to this economy over time. Illustrate with a diagram. b) Describe the policies that the government could use to return the economy to long-run macroeconomic equilibrium, when it is facing a recessionary gap. Illustrate with a diagram. c) What are the advantages and disadvantages of the government implementing policies to close the gap?

Answer 1

In following graph, long run equilibrium is at point A where aggregate demand (AD0), short-run aggregate supply curve (SRAS0) and long-run aggregate supply curve (LRAS0) intersect with initial price level P0 and real GDP (potential GDP) Y0. When there is recession, it means that real GDP is currently lower than potential GDP and position of AD curve is at AD1 where it intersects SRAS0 at point B with lower price level P1 and lower real GDP Y1, creating a recessionary gap equal to (Y0 - Y1).

(a) If government does not intervene, lower price level decreases cost of inputs, so firms increase production, raising aggregate supply. SRAS curve shifts rightward to SRAS1, intersecting AD1 at point C with further lower price level P2 but restoring real GDP to potential GDP of Y0, eliminating recessionary gap.

(b) If government intervenes, it will use expansionary fiscal policy of increasing government spending and/or decreasing tax, to increase AD. As a result, AD1 will shift rightward until equilibrium is restored at point A with price P0 and real GDP Y0.

(c) A government intervention will shorten the length of recessionary period by stimulating the economy by providing fiscal stimulus. But it has the disadvantage of pushing price level higher, therefore increasing inflation rate.