Finance and the Economy · Seminar 9 · Government economic policy

Closing a recessionary or inflationary gap

Potential output is where LRAS stands. When aggregate demand leaves the economy below it there is a recessionary gap; above it, an inflationary gap. Demand-side policy moves AD to close the gap; supply-side policy moves LRAS itself. Questions 4 and 7.

Pick a scenario. The AD slider is demand-side policy; the LRAS slider is supply-side policy. The shaded band is the output gap.

Aggregate demand (fiscal and monetary policy)

contractexpand

Productive capacity (supply-side policy)

unchangedLRAS right

Output

Output gap

Price level

Policy reading

Twin objectives. Governments aim for short-term stability, damping the swings of real GDP around LRAS, and long-term growth, moving LRAS itself to the right. Monetary and fiscal policy work on the first; supply-side policy on the second.

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