2a Define the terms potential output expansionary gap and re

2.a) Define the terms potential output, expansionary gap, and recessionary gap. Hints: See the section of our course text called The Natural Rate of Unemployment in Chapter 7 and the Week Five edition of the TANSTAAFL TRIBUNE b) Why might actual output exceed potential output (an expansionary gap)? Why might actual output be lower than potential output (a recessionary gap)? Hints: See the Week Five edition of the TANSTAAFL TRIBUNE Friendly Reminder: Your initial responses (answers) to the DQ\'s are not considered as participation. However, your responses to classmates answers are considered participation. If you have questions about the participation requirements, please see the syllabus You must start a thread before you can read and reply to other threads Discussion Question #3-Due Friday ?01

Solution

Potential output represents the maximum output that the economy can produce with its given resources and available Technology, considering that all the resources are fully employed. An expansionary gap results when the actual output exceeds the potential output. This is the result of overheating of the economy. Recessionary gap is considered to be a negative output gap where actual output is less than potential output.

There are number of reasons for expansionary gap. When the aggregate demand increases beyond the full employment level, actual output exceeds the potential output. There can be increased aggregate demand due to increased government spending, reduced taxes and increased money supply.

Similarly aggregate demand can shift back and the reason for the shift include increased taxes reduced government spending and reduced money supply. These are demand side factors. On the supply side aggregate supply can also shift to the right when there is a technological advancement increasing the productivity or there is a positive supply shock. This will result in an expansionary gap. Recessionary gap can also be the result from an aggregate supply shock especially with oil price shock.