Macroeconomic equilibrium is determined by the interaction between aggregate demand and aggregate supply and the level of GDP is consistent with given price level oat the equilibrium point. There is no gap between the actual output and the potential output when GDP is in equilibrium position.

Potential output is the total output that can be produced when all the productive resources are being used at their normal rate of utilization. However, if potential output is more than or less than actual output, it causes output gap or GDP gap. In case equilibrium GDP falls short of potential output, it is called recessionary gap for deflationary gap). Similarly, when equilibrium GDP exceeds potential output, it is called inflationary gap. The GDP gap puts pressure on both input prices and output.

GDP gaps put pressure on the input prices. When actual GDP exceeds potential output the result is the inflationary gap. The inflationary gap causes increase in the demand for all the inputs, including the demand for labour. As a result, input prices increase.

Conversely, if the actual GDP falls short of potential output, it causes deflationary gap (or recessionary gap). Recessionary conditions in the economy cause a decrease  in the demand for all the inputs, including the demand for labour. As a result, inputs prices decline. Inflationary gap and deflationary gap are shown.


In (i) actual GDP level Y₀ is less than potential GDP level Y*. The GDP gap is Y*-Y^₀ and it is called deflationary (recessionary) gap. Since actual GDP is less than potential GDP, the demand for all inputs, including that of labour, decreases and the input prices fall.

In (ii) point E₀ is the equilibrium point where AD curve intersects SRAS curve. The equilibrium level of output or actual GDP is Y₀, which is more than potential GDP level  Y*. The GDP gap is Y^₀-Y*, and it is called inflationary gap. Since the actual GDP is more than potential GDP, the demand for inputs rises, causing increase in their prices.

Potential GDP is characterized by the stability of input prices. When the actual output (GDP) equals the potential output (GDP) input prices have no tendency to rise or fall. It  is only in case of output gap (GDP gap) that inputs prices have a tendency to rise or fall.

In case of macroeconomic equilibrium, the aggregate demand curve intersects the aggregate supply curve at a point where the actual output is equal to the potential output. But, we can consider a situation when AD curve intersects SRAS curve at a point where actual GDP exceeds potential GDP, as shown in (i) It Suggests that the firms make larger demand for all inputs, including labour. Tight labour market conditions improve the bargaining power of workers, and they will put pressure on the producers to pay higher wages, even higher than their marginal productivity.

In brief, under conditions of inflationary gap, when the firms are producing more than their normal capacities, not only the firms get larger profits but the workers also succeed in getting higher wages.

Sometimes the AD curve may intersect the SRAS curve at a point when the actual GDP may be less than the potential GDP, as shown (ii) It implies that the firms are producing at a less than their normal capacity. The firms will make lesser demand for all inputs, including the demand for labour. Excess supply of labour rescues their bargaining power. Firms will also resist any pressure for increase in wages, infect, they may resort reduction in wage rates or opt for increase in money wages less than the increase in the marginal productivity of workers.

In brief, under recessionary conditions when the actual output is less than the potential output, firm’s profits decline and they will decide to reduce the money wages.

During inflationary conditions wages have a tendency to increase; while under recessionary conditions, wages have a tendency to fall. But, there is an asymmetry in the way in which the economy responds to each so the GDP gap.

Under inflationary conditions money wages increase in larger proportion than increase in the marginal productivity of the workers. For example, if the money wages rise by 8 per cent and productivity rises by 3 per cent, then the unit cost of labour will increase by 5 per cent. On the contrary, under recessionary conditions, suppose the productivity of workers rises by 2 per cent and money wages fall by 1 per cent. In this case unit cost of labour decreases, but only by 1 per cent.

In brief, upward and downward adjustment to unit costs to labour varies depending upon the state of business activities. Excess demand for labour during boom can cause unit labour costs to rise very rapidly, whereas excess supply of labour during recessionary condition normally causes unit labour costs to fall only slowly.

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