This AE is based on how recent events (COVID-19, inflation) are affecting the US economy. Currently, the US has a small inflationary gap.

Figure 1, below, shows that the unemployment rate (red line) that we learned about in Module 3, is below the natural rate of unemployment (blue line), which is a sign of an inflationary gap.

Figure 1: The unemployment rate (red line) and natural rate of unemployment

For this assignment, it will help to review the section Long-Run Macroeconomic Equilibrium in Chapter 27.3 and Macroeconomic Policy in Chapter 27.4. The sections describe how the economy can respond to an output gap (without government policy interventions) by self-correcting.

A key assumption of the AS-AD model discussed in Chapter 27 is that if there is an inflationary gap (with a low unemployment rate), employers will have a hard time retaining and hiring employees. (A low unemployment rate gives workers more power to switch jobs and get hired faster.) Thus, employers will eventually need to raise wage rates to keep their existing and attract new employees.

Figure 2, below, is the graphical AS-AD model of an economy with an inflationary gap. You can see this because the Real GDP indicated by the short-run macroeconomic equilibrium, E1, is Y1 (e.g., $23 trillion just as an example dollar value) which is greater than the Real GDP indicated by YP (e.g., $20 trillion). As the textbook describes (Chapter 27.3-27.4), because the unemployment rate is so low, employers will need to eventually increase nominal wage rates in order to retain and recruit workers. (Additional costs for employers would also rise in an inflationary gap.) These higher and higher labor and other costs eventually result in SRAS decreasing from SRAS1 to SRAS2. With the SRAS at SRAS2, the short-run macroeconomic equilibrium is at E2. At E2, there is no output gap. The level of Real GDP at E2 is at Yp which is the potential output level of Real GDP. The end result is (a) no output gap as real GDP fell back to Yp, (b) the unemployment rate is back up to its natural rate of unemployment, and (c) the price level will is higher.

Figure 2. Long-run effects from an inflationary gap

As just described, todays economy can be modeled. A model is the same as a what other academic disciplines call a theory. In economics, models are often mathematically expressed, ie. graphically.

The model here is the AS-AD model from Chapter 27 in your textbook. The model has different parts as well as assumptions. These parts and assumptions yield the prediction that, all-else-equal, the economy will eventually self-correct, closing the inflationary gap, back to its potential output level of real GDP.

1A. Why would our economy self-correct (without government policy intervention) from an inflationary gap to no output gap?

1B. Why would our economy notself-correct (without government policy intervention) from an inflationary gap to no output gap?

2A. Do you think the economy will self correct? Yes or No?

2B. Briefly justify your decision with at least two supporting reasons. At least one of your reasons should involve at least one economic concept from Module 4. (Answer must be a minimum of three complete sentences.)