Question

You will need to consider two scenarios in this essay question. For both you must describe the problem and solution in the context of the AD/AS model and interpret the effects on inflation and unemployment. Suppose there is a recessionary gap. Explain what this means using the AD/AS model, then describe the fiscal policy and monetary policy measures can address the issue and comment on any drawbacks to this solution. Suppose instead there is an inflationary gap. Explain what this means using the AD/AS model, then describe how fiscal and monetary policy can address the issue and comment on any drawbacks to this solution.

Answer 1

Recessanary gap is the difference between the potential level of output at full employment level and actual output in the economy.Inflationary gap is when aggregate demand is more than the potential output in the economy.During recession unemployment is high and businesses suffer loss.The AD /AS model shows original equilibrium during recession at pt E0 which is quite away from full employment level of output.A tax cut will increase the disposable income of consumers and demand will increase shifting the AD curve to the right.At the new equilibrium level E1,real GDP will rise and unemployment will fall,.the economy has not yet reached full employment level and rise in prices will be minimum.Other policy tools will also affect AD and shift to the right like higher interest rate will discourage borrowing and lower interest rate will increase consumption and investment.If the AD curve shifts to the left then equilibrium quantity of output and price level will fall.Thus expansionary fiscal policy ie increasing government spending and contractionary monetary policy ie lowering interest rate helps in bringing stabilization and reducing recessionary gap.

The draw back is that it does not show that recession will vanish completely and and shows only one time situation.

The AD/AS diagram shows how inflationary pressure may develop if the AD curve continues to shift to the right and the economy is at the full employment level .The demand rises very high and the economy cannot produce beyond full employment level. Rise in input prices also gives rise to inflationary pressure.This causes AS to shift to the left.The government can increase taxes and reduce spending . This reduces demand in the economy.By reducing aggregate demand ,inflation reduces in the economy.Again increased interest rate reduces the cost of borrowing and discourage consumers from borrowing and also from spending.

The AD/AS model shows only one time shift in price level but does not say what will cause inflation to completely go away.