Question

According to economists who believe in a self-regulating economy, what happens-step-by-step - when the economy is in a recessionary gap? What happens when the economy is in an inflationary gap?

Short answer

In a self-regulating economy, during a recessionary gap, the lower demand causes a drop in wages, which reduces production costs, induces higher employment, and enhances consumption, slowly taking the economy back to the potential GDP levels. During an inflationary gap, the high demand leads to higher wages, increasing production costs, reducing supply and slowing down the economy, taking it back to potential output levels.

Step-by-step solution

Understanding a Self-Regulating Economy

In a self-regulating economy, the economy can adjust back to the potential output level over time, without intervention from the government. There are no administrative management or external influences that push this comeback, it is driven by market dynamics like wage and price flexibility.

Recessionary Gap

A recessionary gap occurs when the real GDP is less than the potential GDP at the full employment level. When an economy is in a recessionary gap in a self-regulating economy, the lack of demand for goods and services results in unemployment, leading to a decrease in wages. This fall in wages makes production less costly, leading firms to employ more workers. As employment rate rises, disposable income increases, which leads to more consumption, driving up the aggregate demand. Over time, the economy moves back to the potential output level.

Inflationary Gap

An inflationary gap is the opposite of a recessionary gap and occurs when the real GDP exceeds the potential GDP. The economy is overheated, and there's upward pressure on prices. In a self-regulating economy, the high demand for goods and services leads to full employment and then to higher wages for workers. Higher wages can increase the production cost, which can reduce the supply. As companies produce fewer goods, the aggregate supply decreases, which slows down the economic expansion and drives the economy back to the potential output level.