ECON 295 Chapter 24: Chapter 24.docx
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I) The Adjustment Process
A) Potential Output and Output Gap
Recall that potential output is the total output that can be produced when all productive
resources (land, labour…) are being used at their normal rates of utilization. When a nation’s
actual output diverges from its potential output, the difference is called the output gap.
If the intersection of the AS and the AD curve (equilibrium real GDP) is lower than potential
output then there a recessionary gap. If the intersection is higher than the potential output
then there is an inflationary gap.
B) Factor Prices and the Output Gap
•Output above Potential (Y > Y*)
Sometimes, the AD and AS curves intersect where real GDP exceeds potential output.
Because firms are producing beyond their normal capacity output, there is an unusually
large demand for all factor inputs. This will lead to an increase in factor prices which in turn
will increase the firm’s unit costs. Firms require higher prices in order to continue to produce
that level of output, and the AS curve will shift up. This shift will reduce equilibrium GDP and
raise the price levels. Real GDP moves back towards potential and the inflationary gap
•Output below Potential (Y < Y*)
Sometimes the AD and ASS curves intersect where real GDP is less than potential. In this
case there is an unusually low demand for all factor inputs. The reduction in factor prices will
reduce firm’s unit costs. Firms require lower price in order to continue to supply a given level
of output. The AS curve shifts down, increasing equilibrium real GDP and reducing price
level. Real GDP moves towards potential and the recessionary gap begins to close.
The process of factor-price adjustment will continue as long as output gap remains meaning
that the potential output (Y*) acts as an anchor for the economy.
II) Aggregate Demand and Supply Shocks
A) AD Shocks
•Expansionary Ad shocks: Inflation (p 600)
The adjustment in wages and other factor prices eventually eliminates any boom caused by
a demand shock; real GDP returns to its potential level
•Contractionnary AD shocks
Flexible wages that fall rapidly in the presence of a recessionary gap provide an automatic
adjustment process that pushes the economy back quickly toward potential output.
If wages are downwardly sticky, the economy’s adjustment process is sluggish and thus
recessionary gaps may not be eliminated quickly.
B) AS Shocks
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