Question

Use the aggregate expenditures model (diagram required) to show how government fiscal policy could eliminate either a recessionary expenditure gap or an inflationary expenditure gap. Explain how equal-size increases in G and T could eliminate a recessionary gap and how equal-size decreases in G and T could eliminate an inflationary gap.

Answer 1

The expenditure-output model, sometimes also called the Keynesian cross diagram, determines the equilibrium level of real GDP by the point where the total or aggregate expenditures in the economy are equal to the amount of output produced. The axes of the Keynesian cross diagram presented in Figure below show real GDP on the horizontal axis as a measure of output and aggregate expenditures on the vertical axis as a measure of spending.

The Keynesian cross diagram contains two lines that serve as conceptual guideposts to orient the discussion. The first is a vertical line showing the level of potential GDP. Potential GDP means the quantity of output that the economy can produce with full employment of its labor and physical capital. The second conceptual line on the Keynesian cross diagram is the 45-degree line, which starts at the origin and reaches up and to the right. In this diagram, the 45-degree line shows the set of points where the level of aggregate expenditure in the economy, measured on the vertical axis, is equal to the level of output or national income in the economy, measured by GDP on the horizontal axis.

Recessionary and Inflationary Gaps

In the Keynesian cross diagram, if the aggregate expenditure line intersects the 45-degree line at the level of potential GDP, then the economy is in sound shape. There is no recession, and unemployment is low.

Figure (a) illustrates a situation where the aggregate expenditure line intersects the 45-degree line at point E₀, which is a real GDP of $6,000, and which is below the potential GDP of $7,000. In this situation, the level of aggregate expenditure is too low for GDP to reach its full employment level, and unemployment will occur. The distance between an output level like E₀ that is below potential GDP and the level of potential GDP is called a recessionary gap. Because the equilibrium level of real GDP is so low, firms will not wish to hire the full employment number of workers, and unemployment will be high.

Anything that shifts the aggregate expenditure line down is a potential cause of recession, including a decline in consumption, a rise in savings, a fall in investment, a drop in government spending or a rise in taxes, or a fall in exports or a rise in imports.

The appropriate response to a recessionary gap is for the government to reduce taxes or increase spending so that the aggregate expenditure function shifts up from AE₀ to AE₁. When this shift occurs, the new equilibrium E₁ now occurs at potential GDP as shown in Figure (a).

Figure (b) shows a situation where the aggregate expenditure schedule (AE₀) intersects the 45-degree line above potential GDP. The gap between the level of real GDP at the equilibrium E₀ and potential GDP is called an inflationary gap. An inflationary gap suggests that because the economy cannot produce enough goods and services to absorb this level of aggregate expenditures, the spending will instead cause an inflationary increase in the price level. In this way, even though changes in the price level do not appear explicitly in the Keynesian cross equation, the notion of inflation is implicit in the concept of the inflationary gap.

The appropriate Keynesian response to an inflationary gap is shown in Figure (b). The original intersection of aggregate expenditure line AE₀ and the 45-degree line occurs at $8,000, which is above the level of potential GDP at $7,000. If AE₀ shifts down to AE₁, so that the new equilibrium is at E₁, then the economy will be at potential GDP without pressures for inflationary price increases. The government can achieve a downward shift in aggregate expenditure by increasing taxes on consumers or firms, or by reducing government expenditures