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

Recessionary Gap :

Real GDP and price level of an economy is determined by interaction of aggregate demand and short run aggregate supply curve . When employment falls short of natural level of employment , it produces a lower level of output ,  the aggregate demand and short-run aggregate supply curves intersect to the left of the long-run aggregate supply curve LRAS . This gap formed between the level of real GDP and potential output , when real GDP < potential is called recessionary gap .

a) With real GDP below potential there will be pressure on the price level . Increased unemployment makes nominal wages to fall .  In the long run, the short-run aggregate supply curve shifts back to SRAS₁. In this case, real GDP returns to potential at Y_P, the price level falls back to P₁, and employment returns to its natural level. These adjustments will close the recessionary gap .

b) Government acts to stabilize the economy with expansionary fiscal policy . Government increases purchase of goods and services or cut down tax . Thus people can spend more n consumption . Both leads to increased aggregate demand . AD1 shifts to AD2 to close the gap .

C) There are arguments for and against fiscal policy . Some say that such policy does not actually affect the aggregate demand and market should be self corrective . Expansionary fiscal policy may fuel high levels of inflation . On the other hand if prices are very sticky then self corrective measures will be a very slow process and then government intervention is required .