Assignment 1
1. a) Draw an A.D./A.S. graph showing an inflationary gap.
2.
b) Draw an A.D./A.S. graph showing a recessionary gap.
c)Using the same graphs you have drawn in A and B, show what
the long run equilibrium position would be in each case if the
government did nothing (i.e., let the economy self-adjust).
(30mrks)
: Inflationary Gap
In the long run, the market will eliminate the inflationary gap using the self
adjustment policy as there is shortage in the economy. It is done by increase
in wages which will lead to shift in the short run aggregate supply curve.
There will be higher wages offered which in turn will decrease the Aggregate
supply in the short run leading to leftward shift in the curve from AS to AS
The new equilibrium is achieved at AS' and AD2, which is the short run
curve which also coincides with long run AS curve at E*. Inflationary
gap is eliminated with higher wages and decrease in aggregate supply.
Recessionary Gap
In the long run, the market with recessionary gap will eliminate the
recessionary gap with the help of self adjustment policy. As the output
level is below the full employment level, lower wages will help to
eliminate the gap by increasing the short run aggregate supply curve from
AS to AS'. This will bring the economy to full employment level of
output.
The new equilibrium is achieved at E* where the actual AD' matches
short run aggregate supply curve which is also the point of intersection of
LRAS. Thus full employment level of output is achieved through self
adjustment by lower wages and increased aggregate supply in long run.
2. Explain how the saving function is derived from the consumption
function, and how the saving schedule and graph of the saving function
are constructed (10mrks)
The saving function reflects households' inclination to reserve a portion of their total income.
Symbolically, it is expressed as \( S = f(Y) \), where \( S \) represents saving and \( Y \) denotes
income. The relationship is defined by \( Y = C + S \), indicating that income (\( Y \)) is divided into
consumption (\( C \)) and saving (\( S \)). Therefore, \( S = Y - C \), highlighting that saving is the
residual amount when consumption is subtracted from income.
Variables:
- \( Y \): Income
- \( S \): Saving
- \( C \): Consumption