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

Answer To Try It Problem

To the graph in the previous Try It! problem we add the long-run aggregate supply curve to show that, with output below potential, the U.S. economy in 1933 was in a recessionary gap. The unemployment rate was above the natural rate of unemployment. Indeed, real GDP in 1933 was about 30% below what it had been in 1929, and the unemployment rate had increased from 3% to 25%. Note that during the period of the Great Depression, wages did fall. The notion of nominal wage and other price stickiness discussed in this section should not be construed to mean complete wage and price inflexibility. Rather, during this period, nominal wages and other prices were not flexible enough to restore the economy to the potential level of output. There are two basic choices on how to close recessionary gaps. Nonintervention would mean waiting for wages to fall further. As wages fall, the short-run aggregate supply curve would continue to shift to the right. The alternative would be to use some type of expansionary policy. This would shift the aggregate demand curve to the right. These two options were illustrated in Figure 7.15 "Alternatives in Closing an Inflationary Gap".