CDS (I) 2021 General Knowledge · Question 26 of 120

Correct — A, Recessionary gap. The stem sets two quantities against each other — the level of real GDP the economy actually settles at, and the potential GDP it would produce with its resources fully employed — and names the case where the first is below the second. That shortfall is the recessionary gap, also called a deflationary gap, and the adjective explains itself: with output below capacity there is unused plant and unemployed labour, so demand is deficient and prices are under downward rather than upward pressure. The standard remedy follows from the diagnosis. Since the shortfall is a shortfall of aggregate demand, it is met by expansionary policy — more government spending, lower taxes, easier credit — which is exactly why an item on public projects in a recession sits in the same family of questions. Question 1 of this paper defines potential GDP, so the two items are two halves of one idea.

• (b)Inflationary gap — The opposite case, and the option that punishes a hurried reading. An inflationary gap arises when equilibrium real GDP exceeds potential GDP — demand outruns what the economy can produce at full employment, so the excess shows up in prices. Same measurement, opposite sign.
• (c)Demand-side inflation — Names a cause of rising prices rather than a gap between two output levels. Demand-pull inflation is what an inflationary gap produces, so this option belongs on the other side of the comparison entirely.
• (d)Supply-side inflation — Cost-push inflation, driven by a rise in input costs such as an oil shock. It can coexist with output below potential — that pairing is stagflation, which question 3 of this paper asks about — but it is a description of why prices rise, not the name for an output shortfall.

Potential GDP is the output an economy can sustain with its labour and capital fully employed. Actual output rarely sits exactly there, and the difference is the output gap. A negative gap, with actual below potential, is the recessionary or deflationary gap: unemployment above its normal rate, idle capacity and weak price pressure. A positive gap, with actual above potential, is the inflationary gap: overtime, bottlenecks and rising prices. Because potential output is estimated rather than observed, the size of the gap is always a matter of judgement, which is why central banks argue about it.

Two of the four options are gaps and two are kinds of inflation, so the first move is to notice that the stem asks for a gap. The second is to get the direction right, and the memory hook is that the word carries the consequence — a recessionary gap goes with recession and slack, an inflationary gap with inflation. Anchoring to the exam, this was not an abstract question in early 2021: Indian output had contracted sharply in the pandemic year and was running well below its pre-pandemic path, which is the textbook picture of a negative output gap, and the policy response — public capital spending and a policy rate held at four per cent — is the textbook response to one.

• Potential GDP is the real output an economy would produce with its resources fully employed.
• The output gap is the difference between actual and potential output.
• A recessionary or deflationary gap exists when equilibrium real GDP falls short of potential GDP, and is associated with unemployment and idle capacity.
• An inflationary gap exists when equilibrium real GDP exceeds potential GDP, and shows up as rising prices.
• Demand-pull inflation arises when aggregate demand outruns supply; cost-push or supply-side inflation arises from rising input costs.
• The usual response to a recessionary gap is expansionary fiscal and monetary policy.

• Reversing the direction and choosing the inflationary gap; the stem says real GDP falls short.
• Picking an inflation term when the question asks for the name of a gap.
• Treating potential GDP as a measured number rather than an estimate.

As a name-the-gap item in either direction, or as a policy question asking what should be done when output falls short of potential.

• practice — not a real PYQ

  An economy in which equilibrium real GDP exceeds potential GDP is said to have

  • (a)a recessionary gap
  • (b)an inflationary gap
  • (c)a trade gap
  • (d)a savings-investment gap

  Answer(b) an inflationary gap — demand is outrunning what the economy can produce at full employment, and the excess shows up in prices.

• practice — not a real PYQ

  The measure most appropriate for closing a recessionary gap is

  • (a)raising the policy interest rate
  • (b)cutting public expenditure
  • (c)increasing government spending on public projects
  • (d)raising indirect taxes on essential goods

  Answer(c) increasing government spending on public projects — the gap is a shortfall of aggregate demand, so the remedy is to add to demand rather than to withdraw it.