ECO104 - Self Regulating Economy

The Self-Regulating Economy
Chap -8 Roger A. Arnold

Inflationary Gap and Recessionary gap
• Inflationary gap →
• Unemployment rate < Natural unemployment rate →
• Shortage in labor market → Wages rise → SRAS curve shifts to the left
→
• Economy moves into long-run equilibrium
Inflationary gap
The economy is currently producing a level of

Real GDP in the short run that is greater than
its Natural Real GDP level or potential
output.
The unemployment rate is less than the
natural unemployment rate.
Graph of inflationary gap
Price level LRAS P LRAS
SRAS2
SRAS 2 SRAS 1
1 P2 1
P1 P1
AD AD
real gdp (Y) Y
0 YN Y1 0 Y N Y1
Recessionary gap
• Recessionary gap →
• Unemployment rate > Natural unemployment rate →
• Surplus in labor market → Wages fall → SRAS curve
shifts to the right →
• Economy moves into long-run equilibrium
Recessionary gap
The economy is currently producing a level of

Real GDP in the short run that is smaller than
its Natural Real GDP level or potential
output.
The unemployment rate is greater than the
natural unemployment rate.
Graph of recessionary gap
p P
LRAS LRAS
SRAS SRAS 1
1 1 SRAS2
p1 P1
P2 2 = LR eqm
AD AD
Y (output) Y
0 y2 YN 0 Y2 YN
When current output= natural level of output
current unemployment rate = natural U rate
P LRAS
SRAS There is no need for any auto

• adjustment process. The economy
PE E is in full equilibrium.
AD
Y
0 YN
Questions?
Q1. Explain scenarios of three states of the economy
including the graphs.
Q2. Explain the process of adjustment in the self
regulating economy from short run to long run with help
of diagrams in case of
a)Inflationary gap b) Recessionary gap
Q3. How does government implement monetary policies
in case of recessionary gap and inflationary gap?
Chapter -14 :Monetary Policy and the
Problem of Inflationary gap and
Recessionary Gap
Monetary Policy and a Recessionary Gap
•P LRAS P LRAS
SRAS 1 SRAS
• SRAS2
1 P2 3
2 P1 1 AD2
AD AD 1
Y Y
Expansionary monetary policy forces economy to move to point 3 from 1. (diagram
in right side) Auto adjustment process is shown in diagram in left side.
Monetary Policy and an Inflationary Gap
P LRAS P LRAS
SRAS
Final Eqm 2 SRAS2 SRAS
1 SRAS1
P1 1
AD AD1
2 AD2
0 Y 0 Y
Contractionary monetary policy forces the economy to move from point 1 to 2 in diagram shown in right
side. Diagram in left side shows auto adjustment process.
NONACTIVIST MONETARY
PROPOSALS OR RULE BASED
MONETARY PROPOSALS.
• 1.Constant-money-growth-rate rule.
• 2. Predetermined-money-growth-rate rule.
• 3. The Taylor rule.
• 4. Inflation targeting.
• Question: Discuss the non activist (non – discretionary) monetary

policies adopted by the central Bank. (broad Question)
• Discretionary Monetary Policy
• A) Expansionary and B) Contractionary
Constant-Money-Growth-Rate Rule
• The annual money supply growth rate will be constant at the
average annual growth rate of Real GDP.
• For example, if the average annual Real GDP growth rate is

approximately 3.3 percent, the money supply will be put on
automatic pilot and will be permitted to grow at an annual rate of 3.3
percent. The money supply will grow at this rate regardless of the
state of the economy. Some economists predict that a constant-
money-growth-rate rule will bring about a stable price level over
time. This prediction is based on the equation of exchange (MV ≡ PQ).
Predetermined-Money-Growth-Rate Rule
• The annual growth rate in the money supply will be equal to the average
annual growth rate in Real GDP minus the growth rate in velocity.
• Growth rate of Ms = growth rate of Q – growth rate of V

• With this rule, the growth rate of the money supply is not fixed. It can
vary from year to year, but it is predetermined in that it is dependent on
the growth rates of Real GDP and velocity. Assuming growth rate of
price is zero percent.
• %M+ %V = %P +%Q
• 2% + 1% = 0% +3%
• Growth rate of money supply = 3% -1% =2%
• Growth rate of Money Supply = Growth rate of output – Growth rate
of velocity.
• P = Stable Price level so its growth rate = 0 [ Here V= not constant ]

The Taylor Rule (Proposed by Economist John Taylor)
Federal funds rate is the interest rate banks charge one
another for reserves.
Two objectives:
1. Stabilizing the inflation rate around a low rate.
2. Stabilizing Real GDP around its full- employment level.
Federal funds rate target = Inflation rate + Equilibrium
real federal funds rate+ ½ Inflation gap + ½ Output gap
Explanation of terms in Taylor rule
1.Inflation = This is the current inflation rate.
2. Equilibrium real federal funds rate= The real federal funds rate is
simply the nominal federal funds rate adjusted for inflation. Taylor
assumes the equilibrium real federal funds rate is 2 percent.
3. The inflation gap is the difference between the actual inflation rate
and the target for inflation.
4. The output gap is the percentage difference between actual Real
GDP and its full-employment or natural level.
For example, suppose the current inflation rate is 1 percent, the
equilibrium real federal funds rate is 2 percent, the inflation gap is 1
percent, and the output gap is 2 percent. The federal funds rate target
can be calculated with the formula:
Federal funds rate target = Inflation + Equilibrium real federal funds

rate + inflation gap + Output gap
= 1%+ 2%+ (1%) + (2%) = 4.5%
Inflation Targeting
• For an inflation rate target approach, the Fed would simply undertake
monetary policy actions to keep the actual inflation rate near or at its
target. For example, if its target rate is 2 percent and the actual inflation
rate is, say, 5 percent, it would cut back the growth rate in the money
supply (or the absolute money supply) to bring the actual inflation rate
nearer to the target rate.
• Numerous central banks in the world practice inflation targeting, and they
do announce their targets. For example, the Bank of Canada has set a
target of 2 percent (inflation), and it has been announcing its inflation
target since 1991. Other central banks that practice inflation targeting
include the Bank of England, the Central Bank of Brazil, the Bank of Israel,
and the Reserve Bank of New Zealand.
Question: Discuss briefly the
non activist or rule based
monetary proposals.
You will discuss above 4 proposals briefly in the examination.

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The Self-Regulating Economy

Chap -8 Roger A. Arnold

The economy is currently producing a level of

The economy is currently producing a level of

SRAS There is no need for any auto

• Question: Discuss the non activist (non – discretionary) monetary

• For example, if the average annual Real GDP growth rate is

• Growth rate of Ms = growth rate of Q – growth rate of V

• P = Stable Price level so its growth rate = 0 [ Here V= not constant ]

Federal funds rate target = Inflation + Equilibrium real federal funds

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