Quiz 10: Bringing in the Supply Side: Unemployment and Inflation

Aggregate supply curve The aggregate supply curve shows the total supply of output in an economy at a given price level during a period of time. Reasons for outward shift in aggregate supply curve Since the imported oil price decreases, it leads to a decrease in the production cost, which in turn increases the production. Because when the production cost decreases, it leads to an increase in profit. This profit induces the producers to produce more, which in turn increases the supply. This increase in supply shifts the aggregate supply curve outward to the right. Consequences of the outward shift in aggregate supply curve The outward shift of the aggregate supply curve is caused by increasing supply. The increase in supply reduces the price level and increases the output, income level, and employment.

Recessionary Gap Recessionary gap arises when aggregate demand is lower than the aggregate supply and short run equilibrium in the economy is below the full employment level. Graphical Representation The following figure shows whether the economy has inflationary or recessionary gap. Figure-2 In the above figure, X axis represents the different levels of output and Y axis represents the different levels of price. Here, the upward sloping curve is a supply curve and downward sloping curve is a demand curve. Figure (2) clearly indicates that there exists an inflationary gap when the full employment level of output is $2,800. This is because the equilibrium level of output $3,000 is greater than the full employment level of output $2,800.

Recessionary gap Recessionary gap arises when aggregate demand is lower and short-run equilibrium in an economy is below full employment level. This problem leads to a fall in the nominal wages, which decreases the business costs. Decrease in business cost reduces the price level, thereby leading to deflation. Deflation causes recession in an economy. This deflationary situation increases the consumer's purchasing power and the net exports of the economy, which leads to a reduction in the recessionary gap. Hence, recession gap closes automatically.