Question

Wonderland’s economy is characterized by the following: Inflation has been mild (below 2%) for years. More recently, it is at 1.5%. The natural unemployment rate is estimated to be 5%. For the past 15 months, the unemployment rate has been ranging from 7 to 9% GDP growth rate has been in negative territory for the last three quarters.

Questions: How would you characterize the economy? Recessionary? Inflationary? Briefly explain why. With the help of AD-AS diagram, illustrate the recessionary or inflationary output gap. With the help of AE and 45 degree line (also called Income-expenditure equilibrium or Keynesian Cross), illustrate the recessionary or inflationary gap.

Answer 1

Since inflation is low, GDP growth is negative and unemployment is high, aggregate demand is low, which means the economy is in recession.

In following graph, long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect with long-run equilibrium price level P0 and long-run equilibrium real GDP (potential GDP) Y0. When aggregate demand falls lower, AD curve will shift leftward from AD0 to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real output Y1, with short run recessionary gap of (Y0 - Y1).

In following graph, initial equilibrium is at point A where initial aggregate expenditure line PAE0 intersects 45⁰ line with initial equilibrium aggregate expenditure E0 and output Y0. A decrease in any component of aggregate demand will cause PAE0 to shift down to PAE1. New equilibrium is at point B where PAE1 intersects 45⁰ line with lower equilibrium aggregate expenditure E1 and lower output Y1. Here, short run recessionary gap is (Y0 - Y1).