Output Gaps Flashcards
(22 cards)
What is an output gap?
An output gap occurs when the actual level of output (GDP) differs from the potential level of output (i.e., full employment level of output).
What is a negative output gap?
A negative output gap occurs when actual output (Y₁) is less than potential output (Y_FE). This usually happens during a recession and is also called a recessionary or deflationary gap.
What does a negative output gap indicate about unemployment?
It indicates higher-than-normal unemployment, since the economy is not producing at full capacity.
Which models explain output gaps?
Both Keynesian and Classical models address output gaps, but Keynesians argue for government intervention to close the gap.
What are the relevant curves in an AD/AS model for output gaps?
AD: Aggregate Demand
SRAS: Short-Run Aggregate Supply
LRAS: Long-Run Aggregate Supply
Y_FE: Full employment level of output
P₁: Price level
What is a positive output gap?
A positive output gap occurs when actual output exceeds potential output (Y > Y_FE). This is also called an inflationary gap.
What causes a positive output gap?
It happens when an economy overuses its resources (labor, capital, etc.), producing beyond the sustainable capacity for a short time.
What are the consequences of a positive output gap?
It can lead to an overheating economy, with rising inflation due to excessive demand and pressure on resources.
Can output exceed potential output in the long run?
No, in the Classical model, the LRAS (Long-Run Aggregate Supply) is vertical at Y_FE. Any output above this level is temporary and unsustainable.
Which model assumes price/wage flexibility that closes the output gap over time?
The Classical model assumes that markets self-correct, and the economy returns to full employment (Y_FE) automatically.
What happens when AD shifts right?
Actual output increases, unemployment falls (due to derived demand for labor), and demand-pull inflation may rise.
How does AD shifting right affect trade?
A strong AD can worsen the current account because higher inflation makes exports less competitive and increases imports.
What happens if there’s a large negative output gap and AD increases?
The economy can grow without inflation, as spare capacity absorbs extra demand. Output rises from Y₁ to Y₂, with no upward pressure on PL (price level).
What if AD continues to rise beyond full employment (Y_FE)?
Further AD increases (e.g., AD3) cause inflation (PL rises), as the economy is at or beyond capacity. Growth now comes with inflationary pressure.
What if the economy is already at full employment and AD shifts right?
There will be little to no increase in real output or employment. The main effect will be higher inflation.
Evaluation Tips Using Output Gaps
If AD increases during a recession (large negative output gap), growth can be achieved without inflation.
If AD increases near or beyond full capacity, inflation rises, possibly without any real growth or employment gains.
Consider the position on the AD/AS curve to evaluate whether growth is sustainable and non-inflationary.
Use diagrams (AD/AS with LRAS, Y₁, Y_FE, PL) to show these different outcomes.
What does a rightward shift in LRAS represent?
An increase in the economy’s productive capacity, often due to improved technology, more skilled labor, or capital investment.
What happens if AD doesn’t shift along with LRAS?
No change in output or price level — the new potential output (Y_FE2) is unused. The economy remains stuck at Y₁ with a large negative output gap.
How does the Classical view interpret this?
In the Classical model, the economy automatically adjusts to the new LRAS over time, assuming flexible wages/prices.
How does the Keynesian view differ?
Keynesians argue that without sufficient Aggregate Demand, the increase in LRAS has no effect — especially if there’s a large negative output gap. Demand-side policies are needed.
Can a rightward LRAS shift help the trade balance?
Yes — if it improves productivity, making exports more competitive, it may improve the current account position.
Evaluation Point (Output Gaps & Policy Effectiveness)
Key insight: A shift in LRAS alone is not enough if AD is low — it’s like expanding potential that no one is using.
In a deep recession, supply-side policy has limited short-term effects — need fiscal or monetary policy to boost AD.
Visual tip: Use a diagram with a large gap between AD₁ and LRAS₂ to show this mismatch and justify policy responses.
