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

Learning Objectives

1. Explain and illustrate graphically recessionary and inflationary gaps and relate these gaps to what is happening in the labor market.
2. Identify the various policy choices available when an economy experiences an inflationary or recessionary gap and discuss some of the pros and cons that make these choices controversial.

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 L_e, shown in Panel (a) of Figure 7.10 “A Recessionary Gap”. This level of employment is achieved at a real wage of ω_e. 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.

Figure 7.10 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 Y_P − 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 7.11 “An Inflationary Gap” shows an economy with a natural level of employment of L_e in Panel (a) and potential output of Y_P in Panel (b). If the real wage ω₁ is less than the equilibrium real wage ω_e, 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 − Y_P.

Figure 7.11 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 − Y_P. 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.