Question

Explain the following two cases of self- regulating economy: Inflationary gap and recessionary
gap . Discuss the Govt policy implication for each case.

Answer 1

• When the current or actual output is below potential, there is an increased unemployment and is termed as recessionary Gap (real GDP is lower than it's gross domestic product). Policymakers use stabilization policy or expansionary policy in order to close the gap while increasing real GDP. Monetary policies may also be introduced so as to raise the amount of money in circulation with the help of lowering interest rates and increasing government spending.
• When the current or actual output is above potential and here the demand for goods and services exceeds production and is termed as Inflationary gap (the current real GDP is higher than the potential GDP). Government introduces fiscal policies like decrease or cut in government spending, increase in taxes, issuence of bond and securities, increase in interest rate, and reduction in transfer payment in order to reduce inflationary gap. This leads to shifting of the overall demand for goods as the amount of money within an economy decreases. Also increase in the interest rates will make funds more expensive and hence aggregate demand falls.