1.5 Output Gaps and Adjustments Flashcards
What is a Negative Output Gap?
A negative output gap, also known as a deflationary gap or recessionary gap, occurs when actual economic growth is less than potential economic growth.
What is a Positive Output Gap?
A positive output gap, also known as an inflationary gap, occurs when actual economic growth is greater than potential economic growth.
What is the Classical Model’s response to a decrease in AD and resulting deflationary gap in the short run?
In the short run, if there is a decrease in AD from AD1 to AD2, output will fall from Ye to Y2. Firms would prefer to cut wages and keep their workforce in tact reducing their costs of production returning the economy back to full employment but classical economists argue that there are three reasons why wages will not fall in the short run; they are fixed. The economy will experience a deflationary gap (output below full employment and a fall in demand pull inflationary pressure from P1 to P2).
What is the Classical Model’s response to a decrease in AD and resulting deflationary gap in the long run?
In the long run, deflationary pressure from P1 to P2 and higher unemployment will feed through to lower wages. This is because those who are unemployed will revise down their wage expectations to find work and those in work will revise down their wage expectations to stay in work resulting in a reduction in costs of production for firms shifting SRAS to the right from SRAS1 to SRAS2 where output returns to full employment levels with lower cost push inflation at P3.
What is the Keynesian response to a decrease in AD and resulting deflationary gap?
Keynesians argue that wages are very sticky downwards even in a recession. They say that workers are not receptive to falls in nominal wages regardless of the state of the economy. The Keynesian response would be to boost AD from AD1 to AD2 with active fiscal policy, increases in government spending and cuts to taxation, to increase economic growth from Y1 to Y2 accepting budget deficits as a side effect of dealing with recession before running budget surpluses when the boom returns. Keynesians also argue there will be no inflationary conflict with this management given the large amount of spare capacity with inflation remaining at P1 and a multiplier effect culminating in an even larger final increase in real GDP.
Evaluation 1: Will wages fall in response to a deflationary gap in the short run according to the Classical Model?
Keynesians argue that wages are very sticky downwards even in a recession. They say that workers are not receptive to falls in nominal wages regardless of the state of the economy. As a consequence, policy makers would be waiting for an alteration in the economy that would not come with the economy stuck in recession, a long run equilibrium at P1 and Y1, suffering from negative consequences such as high unemployment, lower incomes and social costs.
Evaluation 2: What is the criticism of the Classical interpretation of macroeconomic adjustment in a recession in terms of time?
Even Keynesians who agree that wages can fall would argue that waiting for a downward wage adjustment may take many years - a major criticism of the classical interpretation of macroeconomic adjustment in a recession. Classical economists give no indication of how long it will take for wages to adjust downwards. The longer it takes, the longer individuals must suffer from the severe consequences of recession aforementioned.
Evaluation 3: Is debt-fueled fiscal policy a better solution according to the Classical Model?
The Keynesian approach to recession would mean building up huge government debt and large budget deficits with politicians not wanting to adopt contractionary fiscal policy during a boom due to the impact it will have on their popularity. The future consequences of this are severe; tax rises and large cuts to government spending. Even more dangerous is if governments are not prudent with contractionary fiscal policy when the recession is over leaving future generations to bear the debt burden. Classical economists argue that the long-term price of Keynesian management outweigh the short-term problems of unemployment and poverty.
What is an Inflationary Gap?
An inflationary gap occurs in the short run when actual economic growth exceeds potential economic growth, leading to output beyond full employment levels with demand pull inflationary pressure.
What is the Classical Model’s response to an increase in AD and resulting inflationary gap in the short run?
In the short run, if AD increases from AD1 to AD2, output can increase from Yfe to Y2. At this stage, employers are benefiting in the short run as they can raise their prices from P1 to P2 but keep wages fixed thus increasing profits. Workers are employed from the natural rate of unemployment and existing workers are working longer hours (overtime) to increase production, all without immediate wage increases for the firm to bear. In this case, the economy will experience an inflationary gap (output beyond full employment levels with demand pull inflationary pressure from P1 to P2).
What is the Classical Model’s response to an increase in AD and resulting inflationary gap in the long run?
In the long run, workers will realise their real pay is not rising with higher inflation in the economy, their overtime work is persistent, and there is scarcity of labour with firms competing more over workers. This increases their bargaining power for higher wages, increasing costs of production for firms shifting SRAS to the left from SRAS1 to SRAS2 where output returns to full employment levels but with higher cost push inflation at P3.
What is the Classical Model’s view on sustainably increasing economic growth in the long run through an increase in AD?
Classical economists say there is no way to sustainably increase economic growth in the long run through an increase in AD, the end result will purely be inflationary. The only way to increase economic growth and to reduce the natural rate of unemployment is to use supply-side policies shifting LAS to the right.
Do Keynesians dispute the Classical Model’s view on increasing economic growth in the long run through an increase in AD?
Keynesians do not dispute the Classical Model’s view on increasing economic growth in the long run through an increase in AD but stress this approach to macroeconomic management is only true if the economy is at or very close to full employment.
What is the solution proposed by the Classical Model to reduce the natural rate of unemployment?
The only way to reduce the natural rate of unemployment and increase economic growth sustainably in the long run is to use supply-side policies shifting LAS to the right.
