Question

Define the unique characteristics of the GDP gap and the aggregate demand shortfall measure.

Answer 1

Every economy has a long run equilibrium output level. In the event the economy operates below the long run level then the GDP gap is said to be negative as the economy is operating below potential. If the level of GDP is above the equilibrium level the economy has an inflationery gap. If the economy is below the long run level, its a deflationery gap. If the economy is below the equilibrium level, then there needs to be an increase in aggregate demand to go back to potential. This can happen through expansionery monetary or fiscal policy. If the economy is beyond the potential then a contractionery policy needs to be used. The choice of policy depends on the aggreate demand shortfall and what is needed to go back to equilibrium.