Question

Question 11 (20 points) $550 Consumption Investment Exports Imports Government Spending Taxcs $200 $60 $90 $100 $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 or heither? 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

Answer 1

a) Actual GDP (Y) = Consumption - Taxes + Investment + Government Spending + Exports - Imports

Y = 500 - 70 + 200 + 100 + 60 - 90 = 700

Potential GDP = 800

As actual GDP is less than potential GDP, there occurs recessionary gap in the economy.

b) In the diagram below, there is recessionary gap where Y0 (700, actual output) is less than Y1 (800, potential output).

If government does not adopt any policy to vanish recessionary gap or we can say that economy self correct itself, short run supply curve will shift to its right due to theory of stickiness of nominal wage. As unemployment level is higher when economy is not producing at its potential level of output which will reduce real as well as nominal wage. Fall in nominal wage will reduce cost of prodiction of producers which induce them to hire more labor and raise their output which will shift AS curve to its right to AS1. It result in fall in price from P to P1 and rise in output from Y0 to Y1.

CRAS 'AS AS, to Pi AD2 y y