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The inflationary gap should be interpreted, not as a literal prediction of how large real GDP will be, but as a statement of how much extra aggregate expenditure is in the economy beyond what is needed to reach potential GDP. 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 [link] (b). The original intersection of aggregate expenditure line AE 0 and the 45-degree line occurs at $8,000, which is above the level of potential GDP at $7,000. If AE 0 shifts down to AE 1 , so that the new equilibrium is at E 1 , 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.

The multiplier effect

The Keynesian policy prescription has one final twist. Assume that for a certain economy, the intersection of the aggregate expenditure function and the 45-degree line is at a GDP of 700, while the level of potential GDP for this economy is $800. By how much does government spending need to be increased so that the economy reaches the full employment GDP? The obvious answer might seem to be $800 – $700 = $100; so raise government spending by $100. But that answer is incorrect. A change of, for example, $100 in government expenditures will have an effect of more than $100 on the equilibrium level of real GDP. The reason is that a change in aggregate expenditures circles through the economy: households buy from firms, firms pay workers and suppliers, workers and suppliers buy goods from other firms, those firms pay their workers and suppliers, and so on. In this way, the original change in aggregate expenditures is actually spent more than once. This is called the multiplier effect: An initial increase in spending, cycles repeatedly through the economy and has a larger impact than the initial dollar amount spent.

How does the multiplier work?

To understand how the multiplier effect works, return to the example in which the current equilibrium in the Keynesian cross diagram is a real GDP of $700, or $100 short of the $800 needed to be at full employment, potential GDP. If the government spends $100 to close this gap, someone in the economy receives that spending and can treat it as income. Assume that those who receive this income pay 30% in taxes, save 10% of after-tax income, spend 10% of total income on imports, and then spend the rest on domestically produced goods and services.

As shown in the calculations in [link] and [link] , out of the original $100 in government spending, $53 is left to spend on domestically produced goods and services. That $53 which was spent, becomes income to someone, somewhere in the economy. Those who receive that income also pay 30% in taxes, save 10% of after-tax income, and spend 10% of total income on imports, as shown in [link] , so that an additional $28.09 (that is, 0.53 × $53) is spent in the third round. The people who receive that income then pay taxes, save, and buy imports, and the amount spent in the fourth round is $14.89 (that is, 0.53 × $28.09).

Questions & Answers

An investment account was opened with an initial deposit of $9,600 and earns 7.4% interest, compounded continuously. How much will the account be worth after 15 years?
Kala Reply
lim x to infinity e^1-e^-1/log(1+x)
given eccentricity and a point find the equiation
Moses Reply
12, 17, 22.... 25th term
Alexandra Reply
12, 17, 22.... 25th term
Akash
College algebra is really hard?
Shirleen Reply
Absolutely, for me. My problems with math started in First grade...involving a nun Sister Anastasia, bad vision, talking & getting expelled from Catholic school. When it comes to math I just can't focus and all I can hear is our family silverware banging and clanging on the pink Formica table.
Carole
I'm 13 and I understand it great
AJ
I am 1 year old but I can do it! 1+1=2 proof very hard for me though.
Atone
hi
Adu
Not really they are just easy concepts which can be understood if you have great basics. I am 14 I understood them easily.
Vedant
find the 15th term of the geometric sequince whose first is 18 and last term of 387
Jerwin Reply
I know this work
salma
The given of f(x=x-2. then what is the value of this f(3) 5f(x+1)
virgelyn Reply
hmm well what is the answer
Abhi
how do they get the third part x = (32)5/4
kinnecy Reply
make 5/4 into a mixed number, make that a decimal, and then multiply 32 by the decimal 5/4 turns out to be
AJ
can someone help me with some logarithmic and exponential equations.
Jeffrey Reply
sure. what is your question?
ninjadapaul
20/(×-6^2)
Salomon
okay, so you have 6 raised to the power of 2. what is that part of your answer
ninjadapaul
I don't understand what the A with approx sign and the boxed x mean
ninjadapaul
it think it's written 20/(X-6)^2 so it's 20 divided by X-6 squared
Salomon
I'm not sure why it wrote it the other way
Salomon
I got X =-6
Salomon
ok. so take the square root of both sides, now you have plus or minus the square root of 20= x-6
ninjadapaul
oops. ignore that.
ninjadapaul
so you not have an equal sign anywhere in the original equation?
ninjadapaul
hmm
Abhi
is it a question of log
Abhi
🤔.
Abhi
I rally confuse this number And equations too I need exactly help
salma
But this is not salma it's Faiza live in lousvile Ky I garbage this so I am going collage with JCTC that the of the collage thank you my friends
salma
Commplementary angles
Idrissa Reply
hello
Sherica
im all ears I need to learn
Sherica
right! what he said ⤴⤴⤴
Tamia
hii
Uday
hi
salma
hi
Ayuba
Hello
opoku
hi
Ali
greetings from Iran
Ali
salut. from Algeria
Bach
hi
Nharnhar
what is a good calculator for all algebra; would a Casio fx 260 work with all algebra equations? please name the cheapest, thanks.
Kevin Reply
a perfect square v²+2v+_
Dearan Reply
kkk nice
Abdirahman Reply
algebra 2 Inequalities:If equation 2 = 0 it is an open set?
Kim Reply
or infinite solutions?
Kim
The answer is neither. The function, 2 = 0 cannot exist. Hence, the function is undefined.
Al
y=10×
Embra Reply
Jeannette has $5 and $10 bills in her wallet. The number of fives is three more than six times the number of tens. Let t represent the number of tens. Write an expression for the number of fives.
August Reply
What is the expressiin for seven less than four times the number of nickels
Leonardo Reply
How do i figure this problem out.
how do you translate this in Algebraic Expressions
linda Reply
why surface tension is zero at critical temperature
Shanjida
I think if critical temperature denote high temperature then a liquid stats boils that time the water stats to evaporate so some moles of h2o to up and due to high temp the bonding break they have low density so it can be a reason
s.
Need to simplify the expresin. 3/7 (x+y)-1/7 (x-1)=
Crystal Reply
. After 3 months on a diet, Lisa had lost 12% of her original weight. She lost 21 pounds. What was Lisa's original weight?
Chris Reply
Equilibrium price is a stable price and it must stay.discuss
Elvis Reply
Card 14 / 21: What are the similarities between a consumer’s budget constraint and society’s production possibilities frontier, not just graphically but analytically?
Ali Reply

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Source:  OpenStax, Principles of macroeconomics for ap® courses. OpenStax CNX. Aug 24, 2015 Download for free at http://legacy.cnx.org/content/col11864/1.2
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