a) Explain how the self-regulating economy works; what happens if the economy is a recessionary gap? b) Explain how the self-regulating economy works; what happens if the economy is an inflationary gap?

Expert Answers

An illustration of the letter 'A' in a speech bubbles

A recessionary gap is whereby the real GDP is way below the expected GDP. It happens as a result of a slowdown in economic activity. Since a self-regulating economy follows the natural laws of supply and demand, business competition is stiff. As more firms enter the market to get a...

Unlock
This Answer Now

Start your 48-hour free trial to unlock this answer and thousands more. Enjoy eNotes ad-free and cancel anytime.

Start your 48-Hour Free Trial

A recessionary gap is whereby the real GDP is way below the expected GDP. It happens as a result of a slowdown in economic activity. Since a self-regulating economy follows the natural laws of supply and demand, business competition is stiff. As more firms enter the market to get a piece of the profit, the long-run profit of businesses goes down. Since the firms still want to maintain the same level of profits, they lay off workers in a bid to cut costs. As a result, the number of unemployed people increases. Other firms will reduce the wage rate. Those that want jobs have to accept the low wages, because they have no other alternative. Ultimately, the demand for goods reduces, since very few people can afford them. The result is a decrease in prices. The self-regulating economy will return to normal after the prices decrease to a new equilibrium point.

An inflationary gap happens when the real GDP is more than the expected GDP. In a self-regulating economy, an inflationary gap happens when demand exceeds supply. Take the example of the gold rush in California during the 1800s. Many Americans rushed to California to grab the opportunity. The demand for gold was high, and it was difficult for firms to meet the demand. The phenomenon led to a steady increase in the price of gold. The prices increased until a new equilibrium price was reached.

Approved by eNotes Editorial Team