![]() ![]() As the nominal wage rises, the short-run aggregate supply curve will begin shifting to the left. Ultimately, the nominal wage will rise as workers seek to restore their lost purchasing power. Because real GDP is above potential, there will be pressure on prices to rise further. The economy with output of Y 2 and price level of P 2 is only in short-run equilibrium there is an inflationary gap equal to the difference between Y 2 and Y P. The economy’s new production level Y 2 exceeds potential output. Firms employ more workers to supply the increased output. The higher price level, combined with a fixed nominal wage, results in a lower real wage. ![]() That will increase real GDP to Y 2 and force the price level up to P 2 in the short run. The aggregate demand curve shifts from AD 1 to AD 2 in Figure 22.15 “Long-Run Adjustment to an Inflationary Gap”. For example, suppose government purchases increase. Now suppose aggregate demand increases because one or more of its components (consumption, investment, government purchases, and net exports) has increased at each price level. In the long run, as price and nominal wages increase, the short-run aggregate supply curve moves to SRAS 2. In Panel (b), the inflationary gap equals Y 1 − Y P.įigure 22.15 Long-Run Adjustment to an Inflationary GapĪn increase in aggregate demand to AD 2 boosts real GDP to Y 2 and the price level to P 2, creating an inflationary gap of Y 2 − Y P. The gap between the level of real GDP and potential output, when real GDP is greater than potential, is called an inflationary gap The gap between the level of real GDP and potential output, when real GDP is greater than potential. As a result, real GDP, Y 1, exceeds potential. If the real wage ω 1 is less than the equilibrium real wage ω e, then employment L 1 will exceed the natural level. Figure 22.14 “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 employment is greater than its natural level, real GDP will also be greater than its potential level. Just as employment can fall short of its natural level, it can also exceed it. Panel (b) shows the recessionary gap Y P − Y 1, 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. If employment is below the natural level, as shown in Panel (a), then output must be below potential. The gap between the level of real GDP and potential output, when real GDP is less than potential, is called a recessionary gap The gap between the level of real GDP and potential output, when real GDP is less than potential. 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). Employment at L 1 falls short of the natural level. Suppose, however, that the initial real wage ω 1 exceeds this equilibrium value. This level of employment is achieved at a real wage of ω e. Suppose an economy’s natural level of employment is L e, shown in Panel (a) of Figure 22.13 “A Recessionary Gap”. The aggregate demand and short-run aggregate supply curves will intersect to the left of the long-run aggregate supply curve. If employment is below the natural level of employment, real GDP will be below potential. When output is below potential, employment is below the natural level.Īt any time, real GDP and the price level are determined by the intersection of the aggregate demand and short-run aggregate supply curves. When output is above potential, employment is above the natural level of employment. In such a situation the economy operates with a gap. Actual output may exceed or fall short of potential output. In the short run, stickiness of nominal wages and other prices can prevent the economy from achieving its potential output. The long run puts a nation’s macroeconomic house in order: only frictional and structural unemployment remain, and the price level is stabilized. 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 intersection of aggregate demand and long-run aggregate supply determines its long-run equilibrium. 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. 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.Explain and illustrate graphically recessionary and inflationary gaps and relate these gaps to what is happening in the labor market. ![]()
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