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Output gaps will stimulate changes in output and input prices. ( recession/boom).

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.

Input Prices and the Output Gap


The output gap provides a convenient measure of the pressure of demand on input prices. When actual GDP is high relative to potential GDP, demand for inputs will also be high. When actual GDP is low relative to potential GDP, demand for inputs will be relatively low. When there is an inflationary gap, actual output exceeds potential, and the demand for labour services will be relatively high. When there is a recessionary gap, actual output is below potential, and the demand for labour services will be relatively low. Each of these situations has implications for wages. Upward and downward wage pressures Upward and downward pressures on wages are associated with various output gaps. When productivity increases workers tend to get more wages. When GDP is at its potential level, wages will tend to be rising at the same rate as productivity is rising. When wages and productivity change proportionately, unit labour costs remain unchanged. Upward pressure on wages means that there is pressure for wages to rise faster than productivity is rising. Downward pressure on wages means that there is pressure for wages to rise more slowly than productivity is rising.

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.

Induced changes in Input Prices


SRAS Price Level Price Level SRAS

E0

Output Gap

E1

Output Gap

AD
Y* Y0 Real GDP Y*

AD
Y1

Real GDP

(1) A recessionary output gap

(2) An inflationary output gap

Long-run consequences of aggregate demand shocks


1. Expansionary Shocks
Price level rises Price Level P1 SRAS0 Price Level Price level rises further SRAS1 SRAS0

E1 E0

P2

E2

P0

AD1
AD0

P1
E0

E1

AD1 AD0
Y* Y1

Y*

Y1

Real GDP Inflationary gap opens

Real GDP Inflationary gap eliminated

(1) Autonomous increase in AD

(2) Induced shift in aggregate supply

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.

Long-run consequences of aggregate demand shocks


2. Contractionary shocks
Price Level P0 Price level falls SRAS0 Price Level Price level falls further SRAS0 SRAS1

E0 E1

P1

E2

P1

AD0
AD1

P2
E0

E1

AD1

Y1

Y*

Y1

Y*

Real GDP Recessionary gap opens Recessionary gap eliminated

Real GDP

(1) Autonomous falls in AD

(2) Induced shift in aggregate supply

The long-run aggregate supply(LRAS) curve


The long run aggregate supply (LRAS) curve shows the relationship between the price level and real GDP after wage rates and all other input costs have been fully adjusted to eliminate any unemployment or overall labour shortages.
LRAS
P2 P1 P1 P0

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.

Government policy and the Business Cycle


Keynesian measures Fiscal stabilization policies:
LRAS AD SRAS0
1

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.

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