What is Recessionary Gap, Inflationary Gap & Stagflation?

Recessionary Gap:

A recessionary gap occurs when the AD curve intersects the SRAS curve at a short run equilibrium level of GDP below potential GDP:

Factors Responsible –

Tight monetary policy

Higher taxes

More pessimistic consumers and businesses

Lower equity and housing prices

When AD curve shifts leftwards from AD1 to AD2, GDP decreases from Y1 to Y2, prices fall from P1 to P2

Ways to recover back from recession-

1) Automatic mechanism

2) Using fiscal & monetary policy to improve our GDP-

Reduce taxes or Increase Govt. spending, Lower Interest Rates or Increase Money Supply

Inflationary Gap:

An inflationary gap occurs when the economy's short run level of equilibrium GDP is above potential GDP, which results in increase in prices.

Factors responsible-

Expansionary monetary policy

Expansionary fiscal policy

More optimistic consumers and businesses

Weaker domestic currency

When AD curve shifts leftwards from AD1 to AD2, GDP increases from Y1 to Y2, prices rise from P1 to P2 and economy expands

Ways to recover back from recession-

1) Automatic mechanism

2) Using fiscal & monetary policy to improve our GDP-

Increase taxes or Decrease Govt spending, Increase Interest rates or Decrease Money Supply

Stagflation:

During stagflation, both inflation and unemployment increases stagflation arises due to decrease in AS.

Ways to recover back from recession-

1) Automatic mechanism

2) Using fiscal & monetary policy to Permanently correct Stagflation-

Increase Input Prices