Question

Diagrammatically represent an economy in (a) an inflationary gap, (b) a recessionary gap, and (c) long-run equilibrium.

Short answer

Inflationary gap diagram shows the AD curve intersecting AS curve to the right of LRAS. Recessionary gap diagram shows the AD curve intersecting AS curve to the left of LRAS. Long-run equilibrium diagram is where the AD curve intersects the AS and LRAS curves at the same one point.

Step-by-step solution

Understanding the Concepts

Inflationary gap is a condition where real GDP is more than potential GDP, indicating a high demand and pushing prices upwards. Recessionary gap, on the other hand, is the condition where real GDP is lower than potential GDP, depicting a scenario where resources are not being fully utilized, leading to lower output and unemployment. Lastly, long-run equilibrium in an economy is a theoretical state where all markets are in equilibrium, and there's no upward or downward pressure on prices, that is, aggregate demand equals the aggregate supply (potential GDP).

Depicting Inflationary Gap

A diagram of an economy in an inflationary gap should contain two axes: one for Real GDP (horizontal) and one for Price Level (vertical). Draw an upward sloping line to represent Aggregate Supply (AS) curve, and a vertical line at potential GDP level for Long Run Aggregate Supply (LRAS). The point where AS and LRAS meet is equilibrium, but in an inflationary gap, the Aggregate Demand (AD) curve intersects the AS curve to the right of LRAS, meaning the real GDP is higher than potential GDP.

Depicting Recessionary Gap

The diagram for recessionary gap is created similarly as in the pervious step, however, the AD curve will intersect the AS curve to the left of LRAS, which means the real GDP is lower than potential GDP.

Depicting Long-run Equilibrium

For this scenario, construct the same AS curve and LRAS line, but make the AD curve intersect both at the same point, indicating that real GDP equals to potential GDP, hence, depicting a long-run equilibrium.