A Strong Dollar Opens a Recessionary Gap

A Strong Dollar Opens a Recessionary Gap, step by step

1. 1

   Long-run equilibrium

   The economy starts in long-run equilibrium, where AD meets SRAS on LRAS. Real GDP is at the full-employment level and unemployment sits at its natural rate.

2. 2

   Net exports (Xn) fall

   The stronger dollar raises the foreign-currency price of American goods and lowers the dollar price of foreign goods, so exports fall and imports rise. Net exports (Xn) are a component of aggregate demand, so spending on domestic output is lower at every price level and AD shifts left. Cheaper imported inputs could lower production costs too, but this question holds input costs constant, so SRAS stays where it is and only AD moves.

3. 3

   A recessionary gap opens

   AD now crosses the unchanged SRAS at a lower price level and at a real GDP below the full-employment level marked by LRAS. Output below potential is a recessionary gap, and unemployment rises above its natural rate. Watch what did not happen: SRAS never shifted, so the fall in output is the economy sliding down along an unchanged SRAS.

4. 4

   Beyond what the graph shows

   The graph stops at the short-run gap. In the long run, high unemployment would slowly push nominal wages down and shift SRAS right until output returned to full employment at a still lower price level, or policymakers could shift AD back right instead. Neither of those moves is drawn on the graph in front of you.

Where it ends up

A fall in net exports shifts AD left, so the price level falls and real GDP falls below full employment, leaving a recessionary gap.

Now draw it yourself

Same graph, graded on whether you move the right curve and leave the rest alone.

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