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If actual output is greater than potential output, there is an inflationary gap associated
with a high level of activity and a tendency for the price level to rise. If actual output is less than potential output, there is a recessionary gap associated with low levels of activity and a tendency for the price level to fall. The long run aggregate supply curve is vertical at the level of potential output. Economic growth determines the position of the long run aggregate supply curve. Shocks to aggregate demand and aggregate supply are associated with business cycles. In principle, fiscal and monetary policies can stabilize cycles and keep GDP close to its potential level.
Actual GDP exceeds potential GDP Firms are producing beyond their normal capacity output, so there is an unusually large demand for all inputs, including labour. Labour shortage may emerge and may demand high wages specially the skilled one. Actual GDP is less than potential GDP Firms are producing below their normal capacity output there is low profits for firms, so there is an unusually less demand for all inputs, including labour. Labour surplus may emerge and may get low wages. However, the experience of most European economies (and other industrial economies, such as the United States and Canada) suggests that the downward pressures on wages during slumps often do not operate as quickly as do the upward pressures during booms. Even, in quite severe recessions, when the price level is fairly stable, money wages may continue to rise, although their rate of increase tends to fall below that of productivity.
E0
Output Gap
E1
Output Gap
AD
Y* Y0 Real GDP Y*
AD
Y1
Real GDP
E1 E0
P2
E2
P0
AD1
AD0
P1
E0
E1
AD1 AD0
Y* Y1
Y*
Y1
The important expansionary demand shock sequence can be summarized as follows. 1. Starting from full employment, a rise in aggregate demand raises the price level and raises output above its potential level as the economy expands along a given SRAS curve. 2. The expansion of output beyond its normal capacity level puts pressure on input (especially labour) markets; input prices begin to increase faster than productivity, shifting the SRAS curve upward, such that prices are higher at every level of output. 3. The shift of the SRAS curve causes GDP to fall along the AD curve. This process continues as long as actual output exceeds potential output. Therefore, actual output eventually falls back to its potential level. The price level, however, is now higher than it was after the initial impact of the increased AD, but inflation will have come to a halt.
E0 E1
P1
E2
P1
AD0
AD1
P2
E0
E1
AD1
Y1
Y*
Y1
Y*
Real GDP
LRAS 0
LRAS 0
LRAS 1
AD1 AD0 Y1
P0 P2
AD0 Y1 Y2
Y1
Real GDP
Cyclical Fluctuations Cyclical fluctuations in GDP are caused by shifts in the AD and SRAS curves that cause actual GDP to deviate temporarily from potential GDP. These shifts in turn are caused by changes in a variety of factors, including interest rates, exchange rates, consumer and business confidence, and government policy.
1.
AD0 P0 P1 Y0
e0
LRAS
SRAS0
2.
AD P2 P0
0
SRAS1
e1 e0
e1
Y*
Y0
Y*
A recessionary gap may be removed by a rightward shift of the SRAS curve, a natural revival of private sector demand, or a fiscal policy induced increase in AD. The gap might also be removed by a shift of AD curve. That occurs because of a natural revival of private sector spending or because of a fiscal policy induced increase in spending.
1.
LRAS SRAS1
2.
LRAS SRAS0
SRAS0
P1 P0
e1 e0
P0 P2 AD0
e2
e0
AD0 AD1
Y*
Y0
Y*
Y0
An inflationary gap may be removed by a leftward shift of the SRAS curve, a reduction in private sector demand, or a fiscal policy induced reduction in AD. The gap might also be removed by a shift of AD curve. That occurs because of a fall in private sector spending or because of contractionary fiscal policy.