SELF REGULATING ECONOMY

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Classical economists believe in self-regulating economy. Wage rate and prices are flexible. Through the market mechanism, economy will move towards long run equilibrium.

 

Recessionary gap

 

If real GDP < Natural real GDP (full employment GDP), then a recessionary gap exist. At the same time: Unemployment rate > natural rate of unemployment. Since more job seekers are in the market, they tend to settle with a lower wage. Lower wage will raise the short run AS curve and causing the price to decrease. Lower price will increase consumption. This process will continue until the economy reaches the long run equilibrium (natural real GDP).

 

Inflationary gap

If real GDP > Natural real GDP (full employment GDP), then an inflationary gap exist. At the same time: Unemployment rate < natural rate of unemployment. Since job seekers are less than job openings in the market, employers are forced to raise the wage to attract new workers. High wage will decrease the short run AS, and raise the price. Higher price will lower consumption. This process will repeat until the long run equilibrium is reached.