Question

Question 33 (20 points) Consumption $550 Investment $200 Exports $60 Imports $90 Government Spending $100 Taxes $70 Potential Real Output (Long $800 run Real Output) The above macroeconomic data are from the economy in 2019. Dollar values are measured in billions of 2019 dollars. (a) is the economy facing a recessionary gap, an inflationary gap, or neither? Explain using numbers. (b) Based on your answer to part (a), how will the economy adjust in the long run in the absence of any government policy action? Explain. wed Parapranh R en O

Answer 1

(a) GDP = Consumption + Investment + Government spending + Exports - Imports

=> GDP = $550 + $200 + $100 + 60 - $90

=> GDP = $820

Equilibrium GDP is $820 and Potential Real Output is $800.

Since the equilibrium GDP is higher than Potential Real Output, means there is inflationary gap of $20 (i.e., $820 - $800 = $20)

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(b)

Self correction mechanism will adjust the economy in the long run (without any government policy action) and bring back the economy to potential level of real output.

Self correction mechanism in case of inflationary gap.

The economy is already producing more than potential level, it means the labors are overemployed. Hence, there will be rise in the wages which increase the cost of production and shifts the short run aggregate supply curve to the left. SRAS will shifts left enough to intersects LRAS and AD at a common point. Thus, the economy will achieve the long run equilibrium point.

LRAS SRAS SRAS Inflationary Gap Price AD Real GDP