Question

what is an expansionary gap and what kind of pressure does it expert on the price level? What change in the short-run aggregate supply curve resolves an expansionary gap? what is an recessionary gap and what kind of pressure does it excerpt on the price level? describe the process by which a recessionary gap is resolved? With examples for all.

Answer 1

Expansionary gap is a situation where the economy’s aggregate spending is more than its full employment level of output. A situation of excess demand occurs where the economy’s aggregate level of spending is more than the available supply of goods and services—a situation of AD > AS arises leading to excess demand. The output or the aggregate supply cannot be increased since the economy is already operating at full employment level of output. This causes shortage of goods and services , prices rise as a result of demand factors and the general price level rises leading to an inflationary situation where the purchasing power of money falls.

This situation is generally caused when the households spend more due to a rise in their propensity to consume. This fuels the aggregate demand and the spending exceeds the available supply of goods and services causing a rise in price level. Other reasons could be a rise in the investment expenditure by firms , government spending , rise in exports and so on.

For example, when incomes are rising households tendency is to increase their spending capacity—they are on a spending spree—which could include spending money on luxury goods, foreign holidays, jewellery and so on. This would be beneficial to the economy till the extent where the aggregate supply is able to meet the demand generated. But beyond the full employment capacity , this generates a situation of excess demand and inadequate supply leading to rise in prices to such an extent that even the price of necessities like food, clothing (daily wear) , transport to work and so on rise exorbitantly such that any increase in the wages of the working population is immediately absorbed by the rise in the prices and hence purchasing power of money falls.

The Aggregate  supply curve should shift towards the right , and the aggregate supply should be increased through measures like raising the literacy rate , Improving human capital formation through better skills and knowledge. Increase in the income tax could also have an effect on reducing the spending, since disposable income is curtailed. However , the rise in human skills could lead to situations of unemployment or under employment especially when people realise that the unemployment benefits , given by the government are quite attractive rather than work for low wages.

A recessionary gap on the other hand speaks of low level of aggregate demand at the full employment level. The economy is seen as operating at a less than full employment level with lower levels of income , output and employment generation , which is perceived as much lower than its potential capacity.

The causes for such a situation could be a fall in the aggregate spending by the households possible due to a rise in their propensity to save, a fall in the investment expenditure by firms which was probably fuelled by the fall in the consumption expenditure and so on .

The government should undertake measures like lowering the indirect taxes , which could boost both the production and consumption levels and stimulate investment. Public expenditure on construction of roads and so on should be increased , the government should also undertake provision of subsidies and so on in order to boost the output levels.

In addition , certain policies like promoting exports and giving export related subsidies and incentives to firms will increase the domestic demand for goods and services thereby causing a rise in aggregate demand as well as aggregate supply which could lead the economy towards full employment level.