Question

Q1. What is an inflationary gap? Graph and explain how this occurs and give examples of reasons why this could take place. The same for a recessionary gap.

Q2. What is meant by a stronger dollar on international markets? How is that value determined? (see Giuili video for this chapter). How will this affect the AD in the US?

Answer 1

Answer 2

Q1. Inflationary Gap:

An inflationary gap occurs when the actual output (GDP) in an economy exceeds the potential output (full employment level of GDP) at the current price level. In other words, it represents a situation where aggregate demand (AD) is higher than the economy's productive capacity in the short run. This can lead to upward pressure on prices, causing inflationary pressures in the economy.

Graph and Explanation:

The graph of the inflationary gap shows the aggregate demand (AD) and aggregate supply (AS) curves intersecting at a point where AD is greater than the full employment level of GDP (Yf). The economy is producing at point A, where output exceeds the full employment level, leading to upward pressure on prices (inflation).

Reasons for Inflationary Gap:

1. Excessive Government Spending: If the government increases its spending significantly, it can boost aggregate demand beyond the economy's productive capacity, leading to an inflationary gap.

2. Increase in Consumer Spending: When consumers increase their spending significantly, it can result in higher aggregate demand, potentially surpassing the economy's productive potential.

3. Expansionary Monetary Policy: Central banks can implement expansionary monetary policies, such as lowering interest rates or increasing the money supply, which stimulates spending and demand.

Q1. Recessionary Gap:

A recessionary gap occurs when the actual output (GDP) in an economy falls short of its potential output (full employment level of GDP) at the current price level. In this situation, aggregate demand (AD) is lower than the economy's productive capacity in the short run, leading to economic inefficiency and unemployment.

Graph and Explanation:

The graph of the recessionary gap shows the aggregate demand (AD) and aggregate supply (AS) curves intersecting at a point where AD is below the full employment level of GDP (Yf). The economy is producing at point B, where output is below the full employment level, leading to unemployment and underutilization of resources.

Reasons for Recessionary Gap:

1. Decline in Consumer Spending: If consumers reduce their spending significantly due to factors like economic uncertainty or reduced confidence, it can lead to a decrease in aggregate demand.

2. Fiscal Restraint: Government policies that reduce spending or increase taxes can lead to a decrease in aggregate demand and economic slowdown.

3. Contractionary Monetary Policy: Central banks can implement contractionary monetary policies, such as raising interest rates or reducing the money supply, to control inflation, but this can also lead to reduced spending and lower aggregate demand.

Q2. Stronger Dollar on International Markets:

A stronger dollar refers to a situation where the value of the U.S. dollar (USD) appreciates relative to other currencies in the international foreign exchange markets. This means that each unit of the U.S. dollar can buy more of other currencies. A stronger dollar indicates that the exchange rate of the dollar has increased, making U.S. goods and services relatively more expensive for foreign buyers.

Determinants of a Stronger Dollar:

Several factors can influence the value of the U.S. dollar on international markets:

• Interest rates: Higher interest rates in the U.S. attract foreign investors, increasing demand for the dollar.

• Economic performance: A stronger U.S. economy and higher GDP growth can boost investor confidence in the dollar.

• Capital flows: Large capital inflows into the U.S. drive up demand for the dollar.

• Trade balance: A trade surplus can increase demand for the dollar as foreigners buy U.S. goods and services.

Impact on Aggregate Demand (AD) in the U.S.:

A stronger dollar can affect the AD in the U.S. in the following ways:

1. Exports Decline: A stronger dollar makes U.S. goods and services relatively more expensive for foreign buyers. As a result, U.S. exports may decline, reducing net exports (exports minus imports) and decreasing AD.

2. Imports Increase: A stronger dollar makes foreign goods cheaper for U.S. consumers. This may lead to an increase in imports, which could also reduce AD.

3. Impact on Domestic Industries: Some domestic industries that heavily rely on exports may face challenges due to decreased demand from foreign markets.

Overall, a stronger dollar can lead to a decrease in net exports and potentially reduce AD in the U.S., which may have implications for economic growth and employment.