Lecture 34-Inflationary-Recessionary Gap (LRAS)

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1 Aug 2010
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Tuesday, March 2nd, 2010.
Yp: output when factors of production are utilized at normal rates
Short-Run Equilibrium: Alternative Cases
1. Y < Yp Recessionary gap
2. Y > Yp Inflationary gap
3. Y = Yp Full-employment (real GDP = potential GDP)
What will happen, in the long run, to:
1) The wage rate? FALLS (due to high unemployment)
2) The price level? FALLS (as SRAS shifts right)
3) Aggregate Demand? INCREASES (as price level falls)
4) Real GDP (Y)? INCREASES (to Yp)
Price Level
SRAS
Real GDP
AD
Y
Yp
Inflationary output gap
Price Level
SRAS
Real GDP
AD
Y
Yp
Recessionary output gap
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Recessionary Gap: Self-Correction (in Long Run)
1. Yp ± Y0 = Recessionary Gap
2. Real GDP < Potential GDP =>
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Wage rate ;HYHQWXDOO\
3. :DJH5DWH; !65$60 shifts right to SRAS1
(As costs of production fall, firms expand output)
4. Long-Run Equilibrium occurs at Yp
Summary
Short-Run
AD and SRAS determine real GDP
Time frame: say one year
Remember: factor prices are assumed to be a constant
Long-Run
Real GDP = LRAS (Potential GDP)
Time frame: several years or more
Implications
1. $'³VKRFNFKDQJHUHDO*'3LQshort-run, but not in long-run
2. Fiscal policy (for example) has different short-run and long-run impacts on real GDP
Example
Government increases expenditure (G) by $20 million.
SRAS0
AD
Y0
Yp
LRAS
SRAS1
(w1 < w0)
Y< Yp
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