The economy goes through periods of "booms" and "slumps". These ups and downs are called the trade cycle. [Diagram goes here - download the original pdf to see it.] The long run trend line represents the full-employment position. When national income is equal to the full-employment level unemployment is at a minimum and there are no inflationary or deflationary pressures. During a boom the national income level rises above the full-employment equilibrium level. Workers are put under pressure to work more hours by doing overtime. They respond in the short-run because they are attracted by the prospect of higher pay. There is upwards pressure on wages, which leads to increased costs. Firms run down their stocks to meet the excess demand; the demand conditions invite firms to increase their prices. The result of a boom is to create inflation. The pressure is called an inflationary gap. The inflationary gap is the amount by which the actual expenditure in the economy is in excess of the level of expenditure required for full employment. The economy has its own built-in stabilisers. The inflation during a boom causes export prices to rise; this in turn causes a decrease in demand for exports, which deflates the economy. The government also responds by increasing interest rates to dampen demand. In reverse, when the national income level is below the long-term trend line, there is a shortage of demand in the economy. This creates both a recessionary and a deflationary gap. The recessionary gap is defined as the difference between the full employment level of national income and the actual level of national income. The deflationary gap is defined as the difference between the total expenditure in the economy at full-employment and the actual total expenditure - it is the amount by which the demand in the economy is deficient for full-employment.
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