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Inflationary v. Recessionary Gaps Classical v. Keynesian View “ If Society values full employment as an economic goal, is a capitalist economy inherently capable of achieving that goal without intervention on the part of the government?” Economic Statistics Rules of Thumb Good 2-3% Inflation Bad Bad 3-4% Growth (RGDP) Good Good 4-5% Unemployment Bad PL LRAS SRAS PL0 AD FE 0 Y0 RGDP=Y Long Run Equilibrium at Full Employment AD = SRAS = LRAS Actual GDP (where AD intersects SRAS) = Potential GDP (FE/ LRAS) SRAS0 PL LRAS SRAS1 PL0 PL1 AD FE 0 Y0 Y1 RGDP=Y Classical view of a Recessionary Gap 1. Economy is producing < FE; Actual GDP < Potential GDP 2. # of unemployed > # of job openings 3. W rate is bid down, C of P↓ , shifts SRAS0 to SRAS1 4. PL ? GDP? U? The economy self adjusts! Equilibrium is restored! PL LRAS SRAS0 PL1 PL0 AD0 FE 0 Y0 Y1 AD1 RGDP=Y Keynesian view of a Recessionary Gap 1. Economy is producing < FE; Actual GDP < Potential GDP 2. # of unemployed > # of job openings The economy needs help from the government! 3. Increase G, Increase TP, decrease T, or increase MS to increase AD. 4. PL ? GDP? U? Equilibrium is restored but what happens to inflation? SRAS1 PL LRAS SRAS0 PL1 PL0 AD FE 0 Y1 Y0 RGDP=Y Classical view of an Inflationary Gap 1. Economy is producing beyond FE; Actual GDP > Potential GDP 2. # of unemployed < # of job openings 3. W rate is bid up, C of P ↑, shifts SRAS0 to SRAS1 4. PL ? GDP? U? The economy self adjusts! Equilibrium is restored but…! SRAS1 PL LRAS SRAS0 PL0 PL1 FE 0 Y1 AD1 Y0 AD0 RGDP=Y Keynesian view of an Inflationary Gap 1. Economy is producing beyond FE; Actual GDP > Potential GDP 2. # of unemployed < # of job openings The economy needs help from the government! 3. Decrease G, , decrease TP, increase T, or decrease MS to reduce AD. 4. PL ? GDP? U? Equilibrium is restored but what happens to GDP and U?