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ECO100 - FEB 25

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James Pesando

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Output gaps and self correcting mechanism ● The short run equilibrium (Y* where AD = AS) does not always equal to potential GDP ○ might be a better national income ○ Reasons: ■ Wages and factor prices are sticky ● fixed input costs ● 1) Recessionary Gap: Y* < Yp ● 2) Inflationary Gap: Y* > Yp New information: ● Given that Y* < Yp, what happens in the long run to: (Recessionary gap) ○ Wage rate ■ Falls due to unemployment ○ Price level? ■ Falls as the AS expands (Shifts right) ■ Will impact net exports: P decrease => Export increase ● while exchange rate is held constant ■ Decrease imports ○ Aggregated demand? ■ No shift but a movement along ■ increases as the price level falls ○ Real GDP? ■ Increases to potential (Yp) ○ Potential GDP? ■ Stays the same ● Graph and answer for an inflationary gap Policy ● To eliminate a recession (unemployment), the government has policy options: ○ 1) Do nothing. If we wait long enough, the self correcting mechanism will bring the economy back to the full employment equilibrium ■ Unions might be willing the take decrease in wage rate to keep employment ■ Very slow ■ Wages must fall to eliminate unemployment ○ 2) The government can use expansionary fiscal policy to increase AD to expand real GDP and close the gap ■ Could increase G or decrease T to shift the AD ● Will cause inflation (may crowd out private spending) ● How to determine the magnitude of the expansion? Consider a recessionary gap ● Y* < Yp ● The gov’t does not want to wait for the self correcting mechanism (AS to shift) ● Expands AD by decreasing T ● Price level rise
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