Question

1. Given an economy with the initial condition of 0% inflation and 15% unemployment.

a. Illustrate the initial condition using the Aggregate spending model (a.k.a.

Aggregate Demand and Aggregate Supply graph). What gap are we

experiencing? Draw the graph, label it carefully.

Answer 1

When inflation is 0% and unemployment is 15%, the economy is experiencing a "Recessionary Gap"

In the United States, the natural rate of unemployment is around 4% to 5%. When the economy is at potential GDP, the unemployment rate is near the natural rate of unemployment and inflation is near the federal reserves target of 2%.

However, an unemployment rate of 15% does imply that the economy is in deep recession coupled with the fact that there is no inflation in the economy.

The chart below for the AS-AD model represents this scenario followed by the explanation on the chart.

When the economy is in a "Recessionary Gap" the aggregate demand curve is at AD₁. This is represents output at Y₁ and price levels at P₁.

In a recessionary gap, expansionary fiscal and monetary policies need to be pursued so that the aggregate demand shifts to the right from AD₁ to AD. At the point of intersection of AD, LRAS and SRAS, the economy is at potential output with the output represented by Y and price levels by P.