Question

Below, you are provided with the aggregate demand, short-run aggregate supply, and long-run aggregate supply curves. You will use this information to identify if the economy is experiencing a recessionary gap or an expansionary gap. You will then determine whether expansionary or contractionary fiscal policy is more desirable. 135 Price Level LAS 130 SAS 125 120 115 110 1 105 AD 500 550 600 650 700 750 800 Real GDP (in billions) Part 1: Identify the value of Potential GDP in the economy depicted above. Part 2: Identify the value of Real GDP in the economy depicted above. Part 3: Based on your answers to Part 1 and Part 2, is the economy depicted above experiencing a recessionary or an expansionary gap?

Answer 1

1 - The value of potential GDP in the economy is $ 600 billion.

2 - The value of real GDP in economy is $ 650 billion as the AD and AS curve intersect at this level.

3 - There is expansionary gap in the economy because the value of the Real GDP is more than the potential GDP.

4 - Due to the expansionary gap , the inflationary conditions will be created in economy. To reduce this gap , Contractionary policy will be needed to reduce real GDP and bring it back to potential level.

5 - The government should reduce the Spending. This will decrease the consumption and investment in the economy which will lead to reduction in real GDP and bring the economy back to potential level.