Recessionary and Inflationary Gaps and

supply shocks

It is very rare for a country’s actual output to equal its potential output

- Think back to the PPC - does it seem likely that an economy is going to be operating at its capacity level?

- or is it more common to operate somewhere below

the line?

Recessionary Gap

The amount by which equilibrium output falls short of potential output

Here :SRAS = short run aggregate supply

LRAS = long run aggregate supply

AD = aggregate demand

- this economy is currently producing at the point of equilibrium but could be producing at capacity

output as indicated at the green line.

This, therefore, would simply be the opposite of the recessionary gap:

Inflationary gap

Inflationary gap = the amount by which equilibrium output exceeds potential output.

But... How does an economy operate above potential output

Inflationary gap

here employment may be above the “full employment” level of approx. 5%.at the same time resources may be being used beyond capacity levels.

- that is - no fields left fallow, no renewal measures being taken, etc.

effect of these gaps?

When these situations occur it is necessary for the government and/or banking system to step in and take the appropriate actions.

these actions will work to bring the economy back as close as possible to the capacity level.

supply shock

A drastic change in supply that results in an equally drastic change in prices throughout the economy.