Question

Use the following information to work Problems 17 and 18 In Japan, potential GDP is 600 trillion yen and the table shows the aggregate demand and short-run aggregate supply schedules. $$\begin{array}{ccc} \begin{array}{c} \text { Real GDP } \\ \text { Price } \end{array} & \begin{array}{c} \text { Real GDP supplied } \\ \text { demanded } \end{array} & \begin{array}{c} \text { in the short run } \\ \text { (trillions of 2009 yen) } \end{array} \\ \text { level } & 600 & 400 \\ \hline 75 & 550 & 450 \\ 85 & 500 & 500 \\ 95 & 450 & 550 \\ 105 & 400 & 600 \\ 115 & 350 & 650 \\ 125 & 300 & 700 \end{array}$$ Does Japan have an inflationary gap or a recessionary gap and what is its magnitude?

Short answer

Japan has a recessionary gap of 100 trillion yen.

Step-by-step solution

Identify potential GDP

Potential GDP is given as 600 trillion yen. This is the level of GDP where the economy is at full employment.

Find equilibrium GDP

Identify the price level where real GDP supplied in the short run equals real GDP demanded. From the table, at a price level of 85, both real GDP supplied and demanded are 500 trillion yen.

Determine the type of gap

Compare equilibrium GDP with potential GDP. Potential GDP is 600 trillion yen and equilibrium GDP is 500 trillion yen. Since equilibrium GDP is less than potential GDP, there is a recessionary gap.

Calculate the magnitude of the gap

The difference between potential GDP and equilibrium GDP is the magnitude of the recessionary gap. This equals 600 trillion yen - 500 trillion yen = 100 trillion yen.

Key concepts

potential GDP

Potential GDP is the maximum possible output an economy can achieve when all resources are fully employed. In simple terms, it represents the economy's capacity to produce goods and services without triggering inflation.

In the given exercise, Japan's potential GDP is specified as 600 trillion yen. This figure indicates that when the economy is running smoothly and utilizing all its resources effectively, it produces goods and services worth 600 trillion yen.

Reaching potential GDP means the economy is operating at its full potential, with no excessive unemployment or underutilized resources.

equilibrium GDP

Equilibrium GDP is the point where the quantity of goods and services demanded equals the quantity supplied. This is where the economy is in a state of balance without any upward or downward pressure on prices.

In Japan's case, from the table provided, equilibrium GDP is found at the price level of 85, where both real GDP supplied and demanded are 500 trillion yen.

Unlike potential GDP, which is a kind of

aggregate demand and supply

Aggregate demand (AD) is the total amount of goods and services that all the different sectors of the economy (households, businesses, government, and foreign buyers) are willing and able to purchase at a given overall price level.

Aggregate supply (AS), on the other hand, is the total production of goods and services that firms in an economy are willing to sell at a given overall price level.

The interaction of aggregate demand and short-run aggregate supply determines the equilibrium GDP. In the provided table, various price levels show different real GDP levels where supply and demand either match or differ. This can create gaps that signal different economic conditions like inflation or recession.

inflationary gap

An inflationary gap happens when the actual output is higher than the potential output. This means the demand for goods and services exceeds the economy’s capacity to produce them at current prices, leading to upward pressure on prices and inflation.

Although our example doesn’t present an inflationary gap, it's essential to know that if equilibrium GDP had been higher than potential GDP, Japan would be experiencing an inflationary gap.

For example, if the equilibrium GDP were 650 trillion yen (which exceeds the potential GDP of 600 trillion yen), it would mean there's more demand than the economy can handle, pushing prices up.

short-run aggregate supply

Short-run aggregate supply (SRAS) represents the total production of goods and services in the economy at various price levels in the short-term, assuming some input prices are fixed.

It contrasts with long-run aggregate supply, where input prices are flexible and the economy is at full employment. The short-run aggregate supply curve usually slopes upwards, indicating that higher price levels incentivize firms to produce more.

In our case, the short-run aggregate supply schedules provide various real GDP figures at corresponding price levels. From this, we can pinpoint our equilibrium GDP and assess the economy's performance.