The GDP gap or output gap causes pressure on the input prices. For example, when the actual GDP is higher than the potential GDP, this means the economy is producing more than its normal capacity and thus creating higher demand for inputs. This will naturally lead to an increase in input prices. On the other hand, when actual GDP is lower than then the potential GDP, this means that demand for inputs is also smaller than their availability. This would cause a fall in input prices. This relationship between GDP gap and input prices in true fall all inputs, viz., labor, capital, raw materials, etc. for the sake of simplicity, we focus our attention on one input, viz., labor and study the relationship between wage rate (price of labor) and the GDP gap.
When there is an inflationary gap, actual output exceeds potential, and the demand for labor service will be relatively high. When there is recessionary gap, actual output is below potential, and the demand for labor services will be relatively low.SUBMIT ASSIGNMENT NOW!