💶AP Macroeconomics Review
Inflationary and Recessionary Gaps
Inflationary and Recessionary Gaps
In AP Macroeconomics, the economy isn't always in perfect long-run equilibrium. When it isn't, there is a gap between the equilibrium GDP in the long run and the short(er)-term equilibrium GDP. There are two types of gaps in AP Macro: recessionary and inflationary gaps.
Recessionary Gaps
In a recessionary gap, there is a lower short-run equilibrium value than the long-run equilibrium value and can be visualized by a leftward shift in aggregate demand.
As you can see, there is a lower value for the short-run equilibrium compared to the long run, implying a recessionary gap. Recessionary gaps are characterized by cyclical unemployment above the natural rate and an equilibrium price level that is lower than the long-run equilibrium price level. To close a recessionary gap in the short run, the government can use expansionary fiscal policy (increase government spending or decrease taxes) or the central bank can use expansionary monetary policy. Both policies increase aggregate demand, shifting AD right toward full-employment output.
Long-Run Adjustment
In the long run, a recessionary gap can self-correct. Because output is below full-employment output, unemployment is high. With many workers seeking jobs, nominal wages and other input prices tend to fall. Lower nominal wages decrease firms' production costs, so SRAS shifts right until real GDP returns to full-employment output.
Inflationary Gaps
In an inflationary gap, short-run equilibrium real GDP is greater than full-employment (long-run) real GDP, and it can be visualized by a rightward shift in aggregate demand.
As you can see, there is a higher value for the short-run equilibrium (Ye) compared to the long run (Yf), implying an inflationary gap. Inflationary gaps are characterized by unemployment below the natural rate and an equilibrium price level that is higher than the long-run equilibrium price level. To close an inflationary gap in the short run, the government can use contractionary fiscal policy (decrease government spending or increase taxes) or the central bank can use contractionary monetary policy. Both policies decrease aggregate demand, shifting AD left toward full-employment output.
Long-Run Adjustment
In the long run, an inflationary gap can self-correct. Because output is above full-employment output, unemployment is below the natural rate and labor markets are tight. Nominal wages and other input prices tend to rise. Higher nominal wages increase firms' production costs, so SRAS shifts left until real GDP returns to full-employment output.
Graphs for Policy Changing AD
Remember the policy direction:
- For a recessionary gap, use expansionary fiscal or monetary policy to shift AD right.
- For an inflationary gap, use contractionary fiscal or monetary policy to shift AD left.
Congratulations! You now understand inflationary and recessionary gaps and how they can be created and closed. Good luck!