Consumer Spending Habits: Recessionary GNP Gap

Recessionary GNP Gap A macroeconomic equilibrium need not necessarily occur at level of real GNP that corresponds to potential real GNP. If potential real GNP were attained, the economy would be at full employment. However, in Box 12 the level of aggregate demand is not high enough to generate full employment. The equilibrium level of real GNP is $500 billion below potential real GNP, implying that there is some cyclical unemployment in the economy. In other words, if the level of real GNP corresponding to full employment were attained, the result would be widespread buildup of inventory, which would set up forces that would cause production to decline and move the economy to equilibrium at point E2. The difference between the equilibrium level of real GNP and potential real GNP when the economy is operating at less than full employment is called a recessionary GNP gap. The recessionary GNP gap in Box 12 amounts to $500 billion. It's quite possible for the aggregate demand curve to intersect the aggregate supply curve along the latter's flat portion. In this case the macroeconomic equilibrium would correspond to considerable unemployment of workers and idle capacity in the economy. How an Increase in Aggregate Demand Can Affect the Economy An increase in aggregate demand will put upward pressure on equilibrium real GNP and the price level. The graph in Box 13 shows how an increase in aggregate demand moves the economy to a new macroeconomic equilibrium corresponding to point Ez, at which both real GNP and the price level are higher than at the initial equilibrium corresponding to point E,. The increase in aggregate demand is sufficient to overheat the economy. As a result, equilibrium real GNP rises above potential real GNP, creating an inflationary GNP gap, which is the difference between equilibrium real GNP and potential real GNP when the economy is over-heated. Demand-pull inflation is inflation caused by increases in aggregate demand. When, given aggregate supply, the aggregate demand curve continually shifts outward, the result is upward pressure on prices, which means inflation. A general increase in the availability of money and credit in the economy is a common cause of demand-pull inflation that we'll investigate later on. Increases in the stock of money measured by currency in circulation and bank deposits can cause a process of inflation through their impact on aggregate demand. The extent to which changes in aggregate demand cause changes in aggregate production and the price level depends on how close the economy is to the level of real GNP that corresponds to full employment. Suppose the economy starts the year operating in segment 3 of its aggregate supply curve. Factories and offices are already operating around the clock and there is little unemployment. Under such circumstances the main impact of the increase in aggregate demand will be upward pressure on the price level. There will be little if any, effect on equilibrium real GNP. The economy will move along the portion of its aggregate supply curve that is nearly vertical, as shown in graph A in Box 14. Demand-pull inflation will probably be a very serious problem. When the economy is operating in equilibrium above potential real GNP, steady increases in aggregate demand will surely put sharp steady upward pressure on the price level. On the other hand, if there is considerable unused capacity in the economy and excessive unemployment during the year, then the main effect of the increase in aggregate demand will be an increase in real GNP, with little upward pressure on the price level. For example, government stabilization policies that seek to increase real GNP by increasing aggregate demand can do so with little fear of generating inflation in an economy operating in segment 1 of its aggregate supply curve. In such a case the increase in aggregate demand moves the economy along the relatively flat portion of its aggregate supply curve, as shown in graph B of Box 14. If the economy were in equilibrium at a level of real GNP at which factories and offices were utilized well below capacity levels and there was excessive unemploy-ment, a decrease in aggregate demand would decrease real GNP with little downward pressure on the price level.