## Aggregate Demand and Aggregate Supply Review

### 7.3 Recessionary and Inflationary Gaps and Long-Run

#### Recessionary and Inflationary Gaps

At any time, real GDP and the price level are determined by the intersection of the aggregate demand and short-run aggregate supply curves. If employment is below the natural level of employment, real GDP will be below potential. The aggregate demand and short-run aggregate supply curves will intersect to the left of the long-run aggregate supply curve.

Suppose an economy's natural level of employment is *L*_{e}, shown in Panel (a) of Figure 7.10 "A Recessionary Gap". This level of employment is achieved at a real wage of ω_{e}. Suppose, however, that the initial
real wage ω_{1} exceeds this equilibrium value. Employment at *L*_{1} falls short of the natural level. A lower level of employment produces a lower level of output; the aggregate demand and short-run aggregate
supply curves, *AD* and *SRAS*, intersect to the left of the long-run aggregate supply curve *LRAS* in Panel (b). The gap between the level of real GDP and potential output, when real GDP is less than
potential, is called a **recessionary gap.**

**Figure 7.10** A Recessionary Gap

*If employment is below the natural level, as shown in Panel (a), then output must be below potential. Panel (b) shows the recessionary gap Y _{P} − Y_{1}, which occurs when the aggregate demand curve AD and the short-run aggregate supply curve SRAS intersect to the left of the long-run aggregate supply curve LRAS.*

Just as employment can fall short of its natural level, it can also exceed it. If employment is greater than its natural level, real GDP will also be greater than its potential level. Figure 7.11 "An Inflationary Gap" shows an economy with
a natural level of employment of *L*_{e} in Panel (a) and potential output of *Y*_{P} in Panel (b). If the real wage ω_{1} is less than the equilibrium real wage ω_{e}, then
employment *L*_{1} will exceed the natural level. As a result, real GDP, *Y*_{1}, exceeds potential. The gap between the level of real GDP and potential output, when real GDP is greater than potential,
is called an inflationary gap. In Panel (b), the **inflationary gap** equals *Y*_{1} − *Y*_{P}.

**Figure 7.11** An Inflationary Gap

*Panel (a) shows that if employment is above the natural level, then output must be above potential. The inflationary gap, shown in Panel (b), equals Y _{1} − Y_{P}. The aggregate demand curve AD and the short-run aggregate supply curve SRAS intersect to the right of the long-run aggregate supply curve LRAS.*