9.5 Output Gaps and Public Policy

If the economy faces an output gap, how do we get from that situation to potential output?

Gaps present us with two alternatives. First, we can do nothing. In the long run, real wages will adjust to the equilibrium level, employment will move to its natural level, and real GDP will move to its potential.  Second, we can do something. Faced with recessionary or inflationary gaps, policymakers can undertake policies aimed at shifting the aggregate demand or short-run aggregate supply curves to move the economy to its potential. A policy choice to take no action to try to close a recessionary or an inflationary gap but to allow the economy to adjust on its own to its potential output is a non-intervention policy, such as the two situations discussed in section 9.4. A stabilization policy is a policy in which the government or central bank acts to move the economy to its potential output from the gaps. We will discuss these stabilization policies in the later Fiscal and Monetary Policy chapters.