Aggregate Demand and Aggregate Supply Review
7.3 Recessionary and Inflationary Gaps and Long-Run
Nonintervention or Contractionary Policy?
Figure 7.15 "Alternatives in Closing an Inflationary Gap" illustrates the alternatives for closing an inflationary gap. Employment in an economy with an inflationary gap exceeds its natural level – the quantity of labor demanded exceeds the long-run supply of labor. A nonintervention policy would rely on nominal wages to rise in response to the shortage of labor. As nominal wages rise, the short-run aggregate supply curve begins to shift, as shown in Panel (a), bringing the economy to its potential output when it reaches SRAS2 and P2.
Figure 7.15 Alternatives in Closing an Inflationary Gap
Panel (a) illustrates a gradual closing of an inflationary gap. Under a nonintervention policy, short-run aggregate supply shifts from SRAS1 to SRAS2. Panel (b) shows the effects of contractionary policy to reduce aggregate demand from AD1 to AD2 in order to close the gap.
A stabilization policy that reduces the level of GDP is a contractionary policy. Such a policy would aim at shifting the aggregate demand curve from AD1 to AD2 to close the gap, as shown in Panel (b). A policy to shift the aggregate demand curve to the left would return real GDP to its potential at a price level of P3.
For both kinds of gaps, a combination of letting market forces in the economy close part of the gap and of using stabilization policy to close the rest of the gap is also an option. Later chapters will explain stabilization policies in more detail, but there are essentially two types of stabilization policy: fiscal policy and monetary policy. Fiscal policy is the use of government purchases, transfer payments, and taxes to influence the level of economic activity. Monetary policy is the use of central bank policies to influence the level of economic activity.