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5.3: Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium

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    • Anonymous
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    Learning Objective

    Explain and illustrate graphically recessionary and inflationary gaps and relate these gaps to what is happening in the labor market.

    The intersection of the economy’s aggregate demand and short-run aggregate supply curves determines equilibrium real GDP and price level in the short run. The intersection of aggregate demand and long-run aggregate supply determines its long-run equilibrium. In this section we will examine the process through which an economy moves from equilibrium in the short run to equilibrium in the long run.

    The long run puts a nation’s macroeconomic house in order: only frictional and structural unemployment remain, and the price level is stabilized. In the short run, stickiness of nominal wages and other prices can prevent the economy from achieving its potential output. Actual output may exceed or fall short of potential output. In such a situation the economy operates with a gap. When output is above potential, employment is above the natural level of employment. When output is below potential, employment is below the natural level.

    Recessionary and Inflationary Gaps

    At any time, real GDP and the price level are determined by the intersection of the aggregate demand and short-run aggregate supply curves. If employment is below the natural level of employment, real GDP will be below potential. The aggregate demand and short-run aggregate supply curves will intersect to the left of the long-run aggregate supply curve.

    Suppose an economy’s natural level of employment is Le, shown in Panel (a) of Figure 5.7. This level of employment is achieved at a real wage of ωe. Suppose, however, that the initial real wage ω1 exceeds this equilibrium value. Employment at L1 falls short of the natural level. A lower level of employment produces a lower level of output; the aggregate demand and short-run aggregate supply curves, AD and SRAS, intersect to the left of the long-run aggregate supply curve LRAS in Panel (b). The gap between the level of real GDP and potential output, when real GDP is less than potential, is called a recessionary gap.

     

    c1dc3a21907e43219bda233a29258ac4.jpg
    Figure 5.7 A Recessionary Gap If employment is below the natural level, as shown in Panel (a), then output must be below potential. Panel (b) shows the recessionary gap YP − Y1, which occurs when the aggregate demand curve AD and the short-run aggregate supply curve SRAS intersect to the left of the long-run aggregate supply curve LRAS.

     

    Just as employment can fall short of its natural level, it can also exceed it. If employment is greater than its natural level, real GDP will also be greater than its potential level. Figure 5.8 shows an economy with a natural level of employment of Le in Panel (a) and potential output of YP in Panel (b). If the real wage ω1 is less than the equilibrium real wage ωe, then employment L1 will exceed the natural level. As a result, real GDP, Y1, exceeds potential. The gap between the level of real GDP and potential output, when real GDP is greater than potential, is called an inflationary gap. In Panel (b), the inflationary gap equals Y1 − YP.

     

    3691f7d4a437be5b23d0753a0408ed78.jpg
    Figure 5.8 An Inflationary Gap Panel (a) shows that if employment is above the natural level, then output must be above potential. The inflationary gap, shown in Panel (b), equals Y1 − YP. The aggregate demand curve AD and the short-run aggregate supply curve SRAS intersect to the right of the long-run aggregate supply curve LRAS.

     

    Please note that while the previous examples used output and employment to illustrate the relationship between economic activity and the labor market, it is crucial to recognize that discussions surrounding labor markets often center on the unemployment rate as the primary metric. Generally speaking, when economic output is high, it tends to correlate with lower unemployment, as increased demand for goods and services leads to businesses hiring more workers to meet production needs. Conversely, when output declines, the unemployment rate typically rises, as reduced economic activity often results in job cuts and slower hiring. This relationship underscores the broader economic principle that fluctuations in output directly influence labor market conditions, with periods of growth leading to lower unemployment and recessions or slowdowns resulting in higher unemployment

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