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
- When the aggregate demand and short-run aggregate supply curves intersect below potential output, the economy has a recessionary gap. When they intersect above potential output, the economy has an inflationary gap.
- Inflationary and recessionary gaps are closed as the real wage returns to equilibrium, where the quantity of labor demanded equals the quantity supplied. Because of nominal wage and price stickiness, however, such an adjustment takes time.
- When the economy has a gap, policy makers can choose to do nothing and let the economy return to potential output and the natural level of employment on its own. A policy to take no action to try to close a gap is a nonintervention policy.
- Alternatively, policy makers can choose to try to close a gap by using stabilization policy. Stabilization policy designed to increase real GDP is called expansionary policy. Stabilization policy designed to decrease real GDP is called contractionary policy.