Question

What happens if there is a recessionary gap and an inflationary
gap under Classical Economists views and Keynesians views. Explain clearly with diagram.

Answer 1

CLASSICAL VIEW- as we know that classical economist believed in long run rather than in short run concept. classical economist believed that there is no need of intervention of government in the economy.most important assumption of classical economist that they believed in invisible hand where equilibrium is maintained under automatic forces.

as we can see in the diagram that the first equilibrium is achieved at point 'e' where OP price and OQ quantity is determined to be traded.

now suppose an increase in price takes place then the supplier would be encourage to supply more of the quantity and the consumer on the other hand won't wish to purchase at the increased price therefore there would be a situation where AS>AD and due to this a recession would take place but remember classical economist believed that any disequilibrium would be come to equilibrium automatically therefore when AS>AD then producers need to decline the price of the commodity and they would automatically come at the earlier point.

now suppose the price is declined to OP2 then the supplier would decline the production and consumer would increase their consumption due to availability of the goods at a cheaper price, here the AD>AS and this situation will give rise to the inflationary gap. but again the gap would be filled automatically and restore to the old level at point 'e'

KEYNESIAN POINT OF VIEW-

Keynesian assumed that demand is more important sector than supply therefore he believed that the equilibrium can be achieved without attaining the full employment level in the economy. full employment is not a general feature for any economy , there is always some unemployment in the eocnomy.keynesian described that there would be an important role of the government in the economy and Full employment level is a rare situation in the economy.

when economy is earlier at E1 point it means AD=AS but there is some unemployment in the economy. this phase is known as recessionary gap in the economy. due to lack of money and employment people are getting stucked in vicious circle of poverty.

Keynesian suggested that when recessionary gap exist then government expenditure becomes an essence because government will execute development and capital expenditure then the employment in the economy will rise. and therefore it will come to at point E which represents the full equilibrium level.

after the achievement of full employment level if further investment is made then there would be a huge demand of goods and service and in short run the supply can't be infinity therefore there would be limited supply of goods and services and full manpower would be in use and therefore it will give rise to a situation of inflationary gap.

Keynesian suggested that in both , the recessionary and inflationary gap situation, government will come forward to help by its tools named as FISCAL POLICY AND MONETARY POLICY and therefore it will try to achieve the full employment level which is very rare situation as per Keynesian view.