Inflationary and Recessionary Gaps

The adjustment asymmetry explains the nature of inflationary and recessionary gaps, when actual GDP exceeds the potential GDP, there is excess demand for labor and other inputs. This results in rising per unit cost of production and causes upward shifty in the SRAS curve, which, in turn pushes up the price level. Continued excess input demand and sustained rise in per unit cost result in rising prices and inflation. The term inflationary gap explains this feature of gap between the actual potential GDP.

The larger in the excess of actual output, the greater will be the inflationary pressure.

When the actual GDP is less than the potential GDP, there is lower demand for the labor and other inputs. This would cause a fall in input prices and lowering of per unit cost. But as explained by the adjustment asymmetry, the fall in input price of wages of labor is very slow and sometimes insignificant as compared to the rapid and significant rise in wages under the excess demand conditions. Thus, due to this small fall in per unit cost, the SRAS curve will show a very small downward shift. Therefore, during recession price fall, but the rate of fall is slow due to small or insignificant fall in per unit production cost and the consequent small downward (rightward) shift in the SRAS curve. With costs not falling much, the only alternative open to the firms to protect their profit margins or to avoid losses is to scale down their production level to meet the falling market demand for their output. so the firms will produce less, use lower quantity on inputs and employ less labor. Thus, widespread unemployment is the most obvious consequence of the recessionary output gap.

The term recessionary gap emphasizes this salient feature that high rates of unemployment occur when actual output falls short of potential output.

The consequence of output gaps on per unit cost and the shifts in the SRAS curve are called induced effects of output gaps. These induced effects play an important role in the analysis of long run aggregate demand shocks.