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

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.

Solutions

Expert Solution

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.

Rahul Sunny answered 1 year ago

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