Recessionary and Inflationary Gaps

Potential output, shown as LRAS, is the economy's sustainable ceiling when workers and resources are used at normal rates. Equilibrium output, where short-run AS crosses AD, often lands somewhere else. When equilibrium sits left of LRAS, output is below potential: that's a recessionary gap, and it shows up as idle factories and workers who want jobs but cannot find them. When equilibrium sits right of LRAS, output is above potential: that's an inflationary gap, where factories run overtime and workers log extra hours just to meet demand that outpaces what the economy can sustainably produce.

The economy does not snap back overnight because wages and contracts are sticky. Firms do not cut wages the moment demand drops, and workers do not accept pay cuts easily, so the short-run adjustment back to LRAS takes time, sometimes years. A recessionary gap only closes on its own once wages fall enough for firms to hire again, pushing short-run AS right until it meets LRAS. An inflationary gap closes as rising wages push costs up, shifting short-run AS left and dragging output back down. Both paths are slow and painful, which is exactly why fiscal policy exists.

This gap language sets up the fiscal policy that follows: a recessionary gap calls for expansionary policy, more government spending or lower taxes to push AD right toward LRAS, while an inflationary gap calls for contractionary policy to pull AD back. Seeing the gap on the graph is the diagnosis; the policy is the treatment.