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IAI Actuarial Core Principles · Business Economics · Impact of macroeconomic policies on businesses

A central bank in an economy observes that actual output is well below potential output and unemployment is above its natural rate. Which description best fits the state of the business cycle, and the likely effect on firms?

This is a recessionary gap. Output is below potential and unemployment exceeds its natural rate, so demand is weak, firms have spare capacity and little pricing power. An inflationary gap or boom would show output above potential and tight labour markets, which is not described here.

  1. AA recessionary gap, with weak demand, spare capacity and little pricing power for firmsCorrect
  2. BAn inflationary gap, with strong demand, labour shortages and rising wage costs
  3. CFull-employment equilibrium, with stable prices and normal capacity use
  4. DA boom phase, with firms facing rising input prices and strong sales
  5. A structural surplus, in which unemployment is entirely frictional

Explanation

Output below potential with unemployment above the natural rate describes a recessionary (deflationary) gap. Demand is weak, firms hold spare capacity and cannot easily raise prices. An inflationary gap is the opposite situation, with output above potential.

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