Aggregate Demand and Aggregate Supply Review

Review sections 7.2 and 7.3 of Chapter 7 in order to examine the relationship between the labor market dynamics and the achievement of equlibrium in the short run and the long run. Note the role of wage and price stickiness.

7.3 Recessionary and Inflationary Gaps and Long-Run

Gaps and Public Policy

If the economy faces a gap, how do we get from that situation to potential output?

Gaps present us with two alternatives. First, we can do nothing. In the long run, real wages will adjust to the equilibrium level, employment will move to its natural level, and real GDP will move to its potential. Second, we can do something. Faced with a recessionary or an inflationary gap, policy makers can undertake policies aimed at shifting the aggregate demand or short-run aggregate supply curves in a way that moves the economy to its potential. A policy choice to take no action to try to close a recessionary or an inflationary gap, but to allow the economy to adjust on its own to its potential output, is a nonintervention policy. A policy in which the government or central bank acts to move the economy to its potential output is called a stabilization policy.