Induced Changes in Input Prices

Macroeconomic equilibrium is determined by the interaction between aggregate demand aggregate supply and the level of GDP is consistent with a given price level at the equilibrium point. There is no gap between the actual output and the potential out when GDP is in equilibrium position.

Potential output is the total output that can be produced when all the productive resources are being used at their normal rate of utilisation. However, if potential output is more than or less than actual output, it cause output gap or GDP gap. In case equilibrium GDP falls short of potential output, it is called recessionary gap (or deflationary gap). Similarly, when equilibrium GDP exceeds potential output, it is called inflationary gap. The GDP gap puts pressure on the both input prices and output.

Input Prices and the GDP Gap

GDP gaps put pressure on the input prices. When actual GDP exceeds potential output, the result is the inflectional gap. The inflationary gap cause increase in the demand for all the inputs, including the demand for labour. As a result, inputs prices increase.

Conversely, if the actual GDP falls short of potential output, it causes deflationary gap (or recessionary gap). Recessionary conditions in the economy causes a decrease in the demand for all the inputs, including the demand for labour.

Potential GDP is characterised by the stability of the input prices. When the actual output (GDP) equals the potential output (GDP) input prices have no tendency to rise or fall. It is only in case of output gap (GDP gap) that inputs prices have a tendency to rise or fall.

Actual GDP Exceeds Potential GDP (Inflationary Gap)

In case of macroeconomic equilibrium, the aggregate demand curve intersects the aggregate supply curve at a point where the actual output is equal to the potential output. But, we can consider a situation when AD curve intersects SRAS curve at a point where actual GDP exceeds potential GDP.

In brief, under conditions of inflationary gap, when the firms are producing more than their normal capacities, not only the firms get larger profits but the workers also succeed in getting higher wages.

Actual GDP Less than Potential GDP (Recessionary Gap)

Sometime the AD curve may intersect the SRAS curve at a point when the actual GDP may be less than the potential GDP. It implies that the firms are producing at a less than their normal capacity. The firms will make lesser demand for all inputs, including the demand for labour. Excess supply of labour reduces their bargaining power. Firms will also resist any pressure for increase in wages, infact they may resort to reduction in wage rates or opt for increase in money wages less than the increase in the marginal productivity of workers.

Adjustment Asymmetry

During inflationary conditions wages have a tendency to increase; while under recessionary conditions, wages have a tendency to fall. But, there is an asymmetry in the way in which the economy responds to each of the GDP gap.

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