Economy's Potential: Contractionary & Expansionary Gaps

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  • 0:00 Economic Cycles
  • 0:58 Expansionary Gaps
  • 1:56 Contractionary Gaps
  • 3:28 Graphing the Gaps
  • 5:16 Lesson Summary
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.

We know when the economy is doing well and when it is not. How do economists describe these times? This lesson will look at expansionary and contractionary gaps, as well as the types of unemployment with each.

Economic Cycles

Think of a large shopping mall. Every day, new goods, services, consumers, and producers both enter and leave the mall, concerned with ever-changing priorities. The changes are nothing short of staggering. Now, expand that mall from being scaled to your town to an entire country or even the whole world! Obviously, there is a great deal to keep track of.

In short, the economy never stops moving. While it's hard to imagine an economy moving to the left or right, it is relatively easy to imagine it growing or shrinking. Whenever an economy jumps up or falls down, economists refer to it as a gap. In this lesson, we will take a look at expansionary and contractionary gaps, concerned with when an economy either jumps or falls.

Expansionary Gaps

Most economists, and really most people, like when an economy is in an expansionary gap. From an economic perspective, that means the economy is running at full efficiency. Economists define full efficiency as full employment, meaning that everyone who is able to work is working. This does not necessarily mean that there is zero percent unemployment, which means that there is no one who is looking for a job. After all, someone with only a high school diploma is unlikely to find work as a surgeon.

Also, full employment does allow for frictional unemployment, the unemployment that happens when people are moving on to better jobs. During a period of expansion, the economy has full employment, which means that the resources are being used to their full potential.

Contractionary Gaps

On the contrary, a contractionary gap exists when the economy is not producing at full efficiency. In other words, there is not full employment. In this case, there are two other types of unemployment at play. Cyclical unemployment comes as a result of shifts in the market cycle. If you are a car salesman who has seen their wages drop because people aren't buying as many cars as they did before the contraction began, you may not become unemployed, but you may have to lay off your housecleaner.

Worse still is structural unemployment, by which there are too many people wanting a particular job than there is need for. Once upon a time, TVs were so expensive that it was much cheaper to pay for someone to fix them than it was to purchase a new one. Now, a new TV is not the expense it once was, meaning that the economy cannot employ everyone who wants to be a TV repairman. Instead, many of these individuals became unemployed.

No matter the type of unemployment or the cause of it, a drop from full employment signals to economists that an economy is undergoing a contractionary gap. So far, we have discussed these gaps solely from the perspective of employment. But what if we had to look at it from the entire, or aggregate, supply and demand in the economy? Luckily, economists have a model for that.

Graphing the Gaps

Before we introduce the graphs that help economists explain expansionary and contractionary gaps, let's clarify some terms first. As we said earlier, the word 'aggregate' simply means the total across the economy. Therefore, if I were to say aggregate demand curve, I'm simply talking about combining every demand curve in the economy to produce a single curve. Likewise, aggregate supply refers to total amount of supply throughout the economy.

Short-run aggregate supply refers to the actual supply of an economy in this given instant, whereas long-run aggregate supply refers to the potential of that economy. As a result of it being a measure of potential, it is a straight vertical line. It is vertical because no matter the price changes, it represents the maximum supply capacity of an economy.

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