Question

• Interpret recessionary and expansionary gaps within the economy.
• Explain the inter-workings of fiscal policy tools.
• State how taxation and government spending works.

Answer 1

1. Recessionary gap: it refers to a situation where the economy is producing at a level below the full employment equilibrium output, that is, actual GDP < Potential GDP. This puts a downward pressure on prices in the long run. Recessionary gap = potential GDP - Actual GDP.

Government needs to take expansionary fiscal or monetary policy (to increase Aggregate demand) in order to close the recessionary gap.

Inflationary gap : it refers to a situation where the the economy is producing at a level above the potential GDP, that is, inflationary gap occurs when Actual GDP > potential GDP. This puts a upward pressure on prices in the long run.

Inflationary gap = Actual GDP - potential GDP.

Government needs to take contractionary fiscal or monetary policy to decrease aggregate demand and to close the inflationary gap.