These two output gaps reflect a fundamental aspect of macroeconomics, including most notably the analysis of business cycles and the problems of unemployment and inflation, that perpetually puzzle political leaders. Unemployment is the prime problem of a business-cycle contraction which corresponds to a recessionary gap in the aggregate market. Inflation is the key problem that emerges during a business-cycle expansion which corresponds with an inflationary gap.

Output Gaps

The aggregate market presented in the exhibit to the right provides the basis for understanding these two output gaps. The vertical curve labeled LRAS is the long-run aggregate supply curve which marks full-employment real production. Long-run equilibrium in the aggregate market necessarily results in full-employment real production.

The positively-sloped curve labeled SRAS is the short-run aggregate supply curve. Short-run equilibrium in the aggregate market occurs at the price level and real production corresponding with the intersection of the aggregate demand curve and this SRAS curve. The differences between short-run real production and full-employment real production then generates recessionary and inflationary gaps. However, to identify these gaps, a third curve is needed--the aggregate demand curve. This curve is not yet revealed in the graph. The positioning of the aggregate demand curve determines if a recessionary gap or inflationary gap arises.

Recessionary Gap

The key consequences of this recessionary gap are, most obviously, less real production than that corresponding with full employment and, perhaps most important, more unemployment than that corresponding with full employment. Less production and more unemployment are the prime characteristics of a business-cycle contraction.

A question to consider is what might cause this recessionary gap? The simple answer is that "something" disrupts the long-run aggregate market equilibrium, something creates a short-run equilibrium at less that the full-employment level of real production. But what? In general any shock that shifts one of the three curves--AD, SRAS, or LRAS--can create this recessionary gap. But while any of the three curves could do this, a shift of the AD is the most likely cause.

Inflationary Gap

The key consequences of this inflationary gap are, most obviously, more real production than that corresponding with full employment and, perhaps most important but less obvious, a tendency for greater inflation. Excessive production and inflation are the prime characteristics of a business-cycle expansion that has become excessive.