Two Output Gaps

Output Gaps
Recessionary Gap
Inflationary Gap

This graph presents the two aggregate supply curves--long run and short run--but no aggregate demand curve. The vertical curve labeled LRAS is the long-run aggregate supply curve which marks full-employment real production. The positively-sloped curve labeled SRAS is then the short-run aggregate supply curve. The positioning of the aggregate demand curve and the point of intersection with the short-run aggregate supply curve indicates whether the short-run equilibrium generates a recessionary gap or an inflationary gap.

• Recessionary Gap: Click the [Recessionary Gap] button to reveal this output gap. With a recessionary gap, short-run equilibrium real production is less than full-employment real production, meaning resource markets have surpluses, and in particular labor is unemployed. The long-run result is lower wages and an increase in short-run aggregate supply.


• Inflationary Gap: Click the [Inflationary Gap] button to reveal this output gap. With an inflationary gap, short-run equilibrium real production is greater than full-employment real production, meaning resource markets have shortages, and in particular labor is overemployed. The long-run result is higher wages and a decrease in short-run aggregate supply.

Closing A Recessionary Gap

However, in the long run, wages and resource prices ARE flexible and they DO decline enough to eliminate imbalances in the resource markets. The result of declining wages (and other resource prices) is a reduction in production cost. A decrease in production cost causes an increase in short-run aggregate supply, or a rightward shift of the SRAS curve. Click the [Lower Wages] button to demonstrate.

Note that the SRAS curve shifts rightward until it intersects BOTH the LRAS and AD curves at full-employment real production, which is long-run equilibrium. In particular, the new long-run equilibrium is at the full-employment level of real production. The SRAS curve absolutely MUST shift until this long-run equilibrium is reached. If the aggregate market does NOT reach long-run equilibrium, resource market imbalances persist, resource prices and production cost decline further, and the SRAS curve shifts more. However, once long-run equilibrium is reached, resource market imbalances are eliminated, resource prices and production cost do not change, and the SRAS curve does not shift any further.

Closing An Inflationary Gap

However, in the long run, rising wages and resource prices allow employment to return to its natural, full-employment level and eliminate imbalances in real resource prices. The result of rising wages and resource prices is rising production cost. An increase in production cost causes a decrease in short-run aggregate supply, or a leftward shift of the SRAS curve. Click the [Higher Wages] button to demonstrate.