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Part 2
206 The Macroeconomy: Aggregate Supply and Demand

F I GU R E 5
Recessionary and Inflationary Gaps Revisited

Potential Potential Potential

45° 45° 45°
Real Expenditure

C + I0 + G +
C + I2 + G +
(X “ IM) E
C + I1 + G + (X “ IM)
(X “ IM)


6,000 7,000 7,000 7,000 8,000
Real GDP Real GDP Real GDP

Potential Potential Potential
Inflationary D2
D0 gap
Price Level

E Recessionary

6,000 7,000 7,000 8,000
Real GDP Real GDP Real GDP

NOTE: Real GDP is in billions of dollars per year.

of the C 1 I 1 G 1 (X 2 IM) line. In Chapter 9, we learned of several variables that might
shift the expenditure schedule up and down in this way. One of them was the price level.
The three lower panels portray the same three cases differently”in a way that can tell
us what the price level will be. These diagrams consider both aggregate demand and ag-
gregate supply, and therefore determine both the equilibrium price level and the equilib-
rium GDP at point E”the intersection of the aggregate supply curve SS and the aggregate
demand curve DD. But there are still three possibilities.
In the lower-left panel, aggregate demand is too low to provide jobs for the entire labor
force, so we have a recessionary gap equal to distance EB, or $1,000 billion. This situation
corresponds precisely to the one depicted on the income-expenditure diagram immedi-
ately above it.
In the lower-right panel, aggregate demand is so high that the economy reaches an
equilibrium beyond potential GDP. An inflationary gap equal to BE, or $1,000 billion,
arises, just as in the diagram immediately above it.

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Chapter 10 207
Bringing in the Supply Side: Unemployment and Inflation?

In the lower-middle panel, the aggregate demand curve D1D1 is at just the right level to
produce an equilibrium at potential GDP. Neither an inflationary gap nor a recessionary
gap occurs, as in the diagram just above it.
It may seem, therefore, that we have simply restated our previous conclusions. But, in
fact, we have done much more. For now that we have studied the determination of the
equilibrium price level, we are able to examine how the economy adjusts to either a reces-
sionary gap or an inflationary gap. Specifically, because wages are fixed in the short run,
any one of the three cases depicted in Figure 5 can occur. But, in the long run, wages will
adjust to labor market conditions, which will shift the aggregate supply curve. It is to that
adjustment that we now turn.

Suppose the economy starts with a recessionary gap”that is, an equilibrium below poten-
tial GDP”as depicted in the lower-left panel of Figure 5. Such a situation might be
caused, for example, by inadequate consumer spending or by anemic investment spend-
ing. After the financial crisis (which was centered on the home mortgage market) hit in
2007, many observers began to fear that the United States was headed in that direction for
the first time in years. And these fears mounted in early 2008. But in Japan, recessionary
gaps have been the norm since the early 1990s. What happens when an economy experi-
ences such a recessionary gap?
With equilibrium GDP below potential (point E in Figure 6), jobs will be difficult to find. The
ranks of the unemployed will exceed the number of people who are jobless because of mov-
ing, changing occupations, and so on. In the terminology of Chapter 6, the economy will expe-
rience a considerable amount of cyclical unemployment. Businesses, by contrast, will have little
trouble finding workers, and their current employees will be eager to hang on to their jobs.
Such an environment makes it difficult for workers to win wage increases. Indeed, in
extreme situations, wages may even fall”thereby shifting the aggregate supply curve out-
ward. (Remember: An aggregate supply curve is drawn for a given nominal wage.) But
as the aggregate supply curve shifts to the right”eventually moving from S0S0 to S1S1 in
F I GU R E 6
Figure 6”prices decline and the recessionary gap shrinks. By this process, deflation grad-
ually erodes the recessionary gap”leading eventually to an equilibrium at potential GDP The Elimination of a
Recessionary Gap
(point F in Figure 6).
But there is an important catch. In our modern econ-
omy, this adjustment process proceeds slowly”painfully Potential
slowly. Our brief review of the historical record in Chap- GDP
ter 5 showed that the history of the United States in-
cludes several examples of deflation before World War II S0
but none since then. Not even severe recessions have S1
forced average prices and wages down”although they
Price Level (P )

have certainly slowed their rates of increase to a crawl. D
The only protracted episode of deflation in an advanced
economy since the 1930s is the experience of Japan over E B
roughly the last decade, and even there the rate of defla-
tion has been quite mild. gap

S0 D
Why Nominal Wages and Prices
Won™t Fall (Easily) S1
Exactly why wages and prices rarely fall in a modern econ- 5,000 6,000
omy is still a subject of intense debate among economists. Real GDP (Y )
Some economists emphasize institutional factors such
as minimum wage laws, union contracts, and a variety of NOTE: Amounts are in billions of dollars per year.

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Part 2
208 The Macroeconomy: Aggregate Supply and Demand

government regulations that place legal floors under particular wages and prices. Because
most of these institutions are of recent vintage, this theory successfully explains why wages
and prices fall less frequently now than they did before World War II. But only a small
minority of the U.S. economy is subject to legal restraints on wage and price cutting. So it
seems doubtful that legal restrictions take us very far in explaining sluggish wage-price ad-
justments in the United States. In Europe, however, these institutional factors may be more
Other observers suggest that workers have a profound psychological resistance to
accepting a wage reduction. This theory has roots in psychological research that finds peo-
ple to be far more aggrieved when they suffer an absolute loss (e.g., a nominal wage
reduction) than when they receive only a small gain. So, for example, business may find it
relatively easy to cut the rate of wage increase from 3 percent to 1 percent, but excruciat-
ingly hard to cut it from 1 percent to minus 1 percent. This psychological theory has the
ring of truth. Think how you might react if your boss announced he was cutting your
hourly wage rate. You might quit, or you might devote less care to your job. If the boss
suspects you will react this way, he may be reluctant to cut your wage. Nowadays, gen-
uine wage reductions are rare enough to be newsworthy. But although no one doubts that
wage cuts can damage morale, the psychological theory still must explain why the resist-
ance to wage cuts apparently started only after World War II.
A third explanation is based on a fact we emphasized in Chapter 5”that business cy-
cles have been less severe in the postwar period than they were in the prewar period. As
workers and firms came to realize that recessions would not turn into depressions, the
argument goes, they decided to wait out the bad times rather than accept wage or price
reductions that they would later regret.
Yet another theory is based on the old adage, “You get what you pay for.” The idea is
that workers differ in productivity but that the productivities of individual employees are
difficult to identify. Firms therefore worry that they will lose their best employees if they
reduce wages”because these workers have the best opportunities elsewhere in the econ-
omy. Rather than take this chance, the argument goes, firms prefer to maintain high wages
even in recessions.
Other theories also have been proposed, none of which commands a clear majority
of professional opinion. But regardless of the cause, we may as well accept it as a well-
established fact that wages fall only sluggishly, if at all, when demand is weak.
The implications of this rigidity are quite serious, for a recessionary gap cannot cure
itself without some deflation. And if wages and prices will not fall, recessionary gaps like
EB in Figure 6 will linger for a long time. That is,
When aggregate demand is low, the economy may get stuck with a recessionary gap for
a long time. If wages and prices fall very slowly, the economy will endure a prolonged
period of production below potential GDP.

Does the Economy Have a Self-Correcting Mechanism?
Now a situation like that described earlier would, presumably, not last forever. As the re-
cession lengthened and perhaps deepened, more and more workers would be unable to
find jobs at the prevailing “high” wages. Eventually, their need to be employed would
overwhelm their resistance to wage cuts. Firms, too, would become increasingly willing
to cut prices as the period of weak demand persisted and managers became convinced
that the slump was not merely a temporary aberration. Prices and wages did, in fact, fall
in many countries during the Great Depression of the 1930s, and they have fallen in Japan
for about a decade, albeit very slowly.
Thus, starting from any recessionary gap, the economy will eventually return to
potential GDP”following a path something like the brick-colored arrow from E to F in
Figure 6 on the previous page. For this reason, some economists think of the vertical line
at potential GDP as representing the economy™s long-run aggregate supply curve. But
this “long run” might be long indeed.

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Licensed to:

Chapter 10 209
Bringing in the Supply Side: Unemployment and Inflation?

Nowadays, political leaders of both parties”and in virtually all countries”believe
that it is folly to wait for falling wages and prices to eliminate a recessionary gap. They
agree that government action is both necessary and appropriate under recessionary con-
ditions. Nevertheless, vocal”and highly partisan”debate continues over how much
and what kind of intervention is warranted. One reason for the disagreement is that the
self-correcting mechanism does operate”if only weakly”to cure recessionary gaps. The economy™s self-
correcting mechanism
refers to the way money
wages react to either a re-
An Example from Recent History: Deflation in Japan cessionary gap or an infla-
tionary gap. Wage changes
Fortunately for us, recent U.S. history offers no examples of long-lasting recessionary
shift the aggregate supply
gaps. But the world™s second-largest economy does. The Japanese economy has been
curve and therefore change
weak for most of the period since the early 1990s”including several recessions. As a re-
equilibrium GDP and the
sult, Japan has experienced persistent recessionary gaps for 15 years or so. Unsurpris- equilibrium price level.
ingly, Japan™s modest inflation rate of the early 1990s evaporated and, from 1999 through
2005, turned into a small deflation rate. Qualitatively, this is just the sort of behavior the
theoretical model of the self-correcting mechanism predicts. But it took a long time!
Hence, the practical policy question is: How long can a country afford to wait?


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