Final Assignment

Jannatul Nayeem
NSU ID: 1611482030
ECO 104.11
Spring 2020
 Q/A-1
Recessionary Gap (Classical view):
From the view point of classical economists, there are three possible states in economy that
encompasses few basic economic concepts- GDP, LRAS, SRAS, and unemployment rate.
However, recessionary gap is the economic condition where the unemployment rate is higher
than the natural unemployment rate and GDP is less than the natural real GDP. If the economy
has following attributes, we can conclude that it is in a recessionary gap.

a. U1>UN (Unemployment rate is greater than Natural Unemployment rate)

b. Q1<QN ( Real GDP is less than Natural real GDP)
c. Equilibrium (the current economy) lie before the LRAS.

Q/A-2

LRAS QN = Natural Real GDP

Q1 = Real GDP
SRAS1
Price Level

Current
Economy

AD

0 Q1 QN

Real GDP

figure. Recessionary gap (Classical view)

 Q/A-3

Adjustment of recessionary gap:

Unemployment rate (Higher and surplus in labor market)

Wages rate fall

Cost of production falls

Profit increases

Supply Increases

SRAS shifts right

Since economy is self-regulating according to classical point of view that illustrates as interest
rate, wage rate, and price level are flexible, therefore, economy is supposed to adjust to reach
long run equilibrium state voluntarily. It is expected that during the recessionary stage less
employees are employed which causes surplus in human resources (labor market-precisely).
However, when the wage rate is lower, production cost decreases that results into increased
turnover/profit. Producers are encouraged for more production due to higher profit which causes
higher product supply in market. Therefore, SRAS (Short Run Aggregate Supply) curve shifts
right until it intersects the LRAS (Long Run Aggregate Supply).
 Q/A-4

LRAS QN = Natural Real GDP

Q1 = Real GDP
Q2 = New Quantity
SRAS1 P1= Current Price
P2 = New Price

SRAS2
Price Level

Current
P1 Economy

P2 New
Economy
AD

0 Q1 QN, Q2

Real GDP

figure. Adjustment of recessionary gap (Classical view)

 Q/A-5
Inflationary Gap (Classical view):

Unlike recessionary gap, Inflationary Gap has totally opposite attribute where the Real GDP is
more than the Natural Real GDP, and the Unemployment rate is lower than the Natural
Unemployment rate. During an inflationary gap production and supply are higher. Followings
are the traits of an inflationary gap-

a. U1<UN (Unemployment rate is less than Natural Unemployment rate)

b. Q1>QN ( Real GDP is more than Natural real GDP)
c. Equilibrium (the current economy) lie after the LRAS.

Q/A-6

LRAS QN = Natural Real GDP

Q1 = Real GDP

SRAS1
Price Level

Current
Economy

AD

0 QN Q1

Real GDP

figure. Inflationary gap (Classical view)

 Q/A-7

Adjustment of recessionary gap:

Unemployment rate (Lower and shortage in labor market)

Wages rate rises

Cost of production increases

Profit decreases

Supply decreases

SRAS shifts left

In classical view, variables like wage rate, interest rate, and price level are flexible. In an
inflationary gap, the production in economy is higher that describes as higher Real GDP than
Natural Real GDP. Since the production is higher, it requires more labor. Due to higher
employment, there exists a shortage in labor market that results in higher wage rate. Due to
higher wage rate, cost of production increases and companies earn less profit. Due to less profit
margin, companies sells less, and the supply decreases. Finally, SRAS (Short Run Aggregate
Supply) curve shifts left until it reaches the LRAS (Long Run Aggregate Supply) curve.
 Q/A-8

LRAS QN = Natural Real GDP

Q1 = Real GDP
SRAS2 Q1 = New Quantity
P1= Current Price
P2 = New Price
SRAS1
New
Price Level

P2 Economy

P1 Current
Economy
AD

0 QN Q1

Real GDP

figure. Adjustment of inflationary gap (Classical view)

 Q/A-9
When the economy is in recessionary gap (Keynesian view)

a. Labor Demand (LD) and Labor Supply (LS): In a recessionary gap, companies hire
comparatively less employees as they produce less to combat the economic condition.
However, the Labor Supply (LS) do not get affected by recession since economic
condition is statistically insignificant to have impact on number of human force.
Therefore, with the same level of LS, the demand of labor force will decrease. So, LS
curve will remain constant whereas the (Labor Demand) LD curve will shift left.

b. Equilibrium wage rate: In classical view wage rate goes down in recessionary gap
whereas in Keynesian view wage rate remains might be constant (inflexible) due to 3
factors (Labor Union, Contract, and Efficiency Wage model). Since, in recessionary gap,
the demand for labor (employer’s) decreases (as the economy produces less), and the
wage rate does not fall, therefore, there will be a gap between labor demand of workforce
to work, and the labor demand of employer- called as unemployment. For example- a
company pays $1000 to 100 employees each usually. During recessionary gap, the
company will employ less labor, let’s say-50. As the demand of laborers to work don’t
fall due to inflexible wage rate, therefore, 50 will be the unemployment.
 Q/A-10
a. Wages are not flexible in downward direction: In classical view, interest rate, price
levels, and wage rate are flexible which means they change at different economic
condition. But, Keynes argues with that narrating the fact that wage rate does not change
or it increases usually with time. In classical view, we know that in a recessionary gap,
wage rate falls and price level goes downward. However, in Keynesian view, it does not
decrease, and thereby does not go down. So, the classical view of self-regulating property
of economy does not hold here.
b. Inflexible wage rate in a downward direction: Keynes argues that wage rate is
inflexible in a downward direction because of following 3 reasons-
1. Labor Union: There are certain non-state actors in the government who pursue
certain well-defined right. If an employer wants to cut down the wages, then those
actors will play their role to protest and protect worker’s right to uphold the wage
rate. Therefore, wage rate is unlikely to change.
2. Contract: If not all, most of the companies go run contractual recruitment process.
While hiring the employees, the company sign the agreement of keeping the
workforce for certain duration with certain wages and other conditions. Therefore, it
is not possible legally to cut down the wage rate during recessionary gap.
3. Efficiency Wage Model: To keep the brand resonance intact, companies pay wages
to their employees according to the contract. Moreover, the cost certain skill, for
example- a dentist, cannot be compromised with unexpected economic condition.
Therefore, wage rate does not go down.
c. According to Keynesian view, economy will not recover to Long Run Equilibrium state
unless external forces (e.g. government) have proper measures not that.
In classical view, interest rate, price level, and wage rate are flexible. Classical view
states that since interest is flexible, therefore, people will save money, and the rest
amount will be borrowed by someone else, and it will come to economy. Keynes
disagrees with it, and practically this is not the scenario, as some amount will be left over
in banks. Next, they also believe that due to variability in wage rate there creates
unemployment. However, Keynesian disagrees with classical view. If an economy suffers
from recession for long time, it will have economic depression. It will not recover
automatically, if there is no external force applied.