Suppose governments adopted a hands-off policy to the economy and a recessionary gap occurred.Which of the following could, in theory, overcome this gap in the long run?
A) The only way for the gap to close is for the nominal wage to rise.
B) Such a gap could be closed if the nominal wage grew more slowly over time than the price level.
C) Only a strong reduction in aggregate demand could close the gap.
D) Inflation eventually ends such gaps.

Question

Suppose governments adopted a hands-off policy to the economy and a recessionary gap occurred.Which of the following could, in theory, overcome this gap in the long run?  
A) The only way for the gap to close is for the nominal wage to rise. 
B) Such a gap could be closed if the nominal wage grew more slowly over time than the price level. 
C) Only a strong reduction in aggregate demand could close the gap. 
D) Inflation eventually ends such gaps.

Quizplus · Accepted Answer

In the long run, a recessionary gap can be closed by stabilization policies such as reducing taxes, increasing government spending, and increasing money supply. However, if the government adopts a hands-off policy, the market forces will need to adjust to close the gap. According to the classical theory, prices and wages are flexible, and the market will adjust to the equilibrium level where aggregate supply equals aggregate demand. The nominal wage rate will adjust according to the demand and supply of labor. Therefore, if the nominal wage grows more slowly than the price level, the real wage will fall, leading to an increase in employment and output, and eventually closing the gap. This is the principle of classical economic theory, also known as Say's Law, which assumes that supply creates its demand. Inflation will not necessarily end the gap as it could worsen the situation by reducing the purchasing power of consumers and causing uncertainty in the economy.

Suppose Governments Adopted a Hands-Off Policy to the Economy and a Recessionary