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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

Distinguish between cross elasticity and income elasticity of demand
Ruth Reply
what is the competitive demand
Adiza Reply
With regards to coal shortage and manicipal debts the what form of intervention do you think Eskom can put in place.
kedibone Reply
economic growth of Bhutan
Nima Reply
please, explain all the mathematics terms used in economics
what is the effect of inflation in GDP
ahmed Reply
Not only real GDP but also nominal GDP will decrease
yep. Inflation has an influence not only GDP but interest rate also.
The pound weakens so imports become more expensive and exports lose value - lower GDP.
why do inflation effect economic
Chelsea Reply
explain in detail what is economic what is scarcity what is alternate uses
Ejiro Reply
What is law of demand
economic as a science refers to study of human resource
Law of demand- With all the factors remaining same if price increases of a commodity, the quantity of demand of that commodity decreases and vice versa
Thanks dey sunita
What is law of supply
what are the factors that affect demand
Elly Reply
what are the factors that affect demand of a good
what are the factors that affect demand of a good
what are the factors that affect demand of a commodity
1. the price of the product 2. the price of other products 3. consumers income 4. expectation of future changes in price 5. taste and preference etc.
Change in price
1. price related of commodities 2. consumers income 3. the condition or season of the commodities
decrease in demand of substitute increase in demand of constituent change in quantity and other environmental factors
Nd consumer's income
what course scarcity
Bashari Reply
Scarcity is the limited availability of a commodity, which may be in demand in the market or by the commons. Scarcity also includes an individual's lack of resources to buy commodities. The opposite of scarcity is abundance.
Reasons that explain why the division of labor increases an economy's level of production
Chukwuka Reply
Please I don't understand the meaning and the concept of economics as a science
Ophelia Reply
economics as a science refers to the study of human behavior. how they make decisions etc
economics is science because it uses scientific methods in analysing societal problems.. observation experimentation and conclusion inherently are used to analyse. however it is not pure science but social science because it studies human and it's environs
what's elasticity of demand
Isaac Reply
are u asking because you don't know or what
A measure of the responsiveness of a product demanded to a change in market price
the degree of responsiveness of a product demanded to a little change in the price
the degree of responsiveness of quantity demanded of a commodity to the changes in the price if the commodity in question, changes in the price of other related commodities and changes in the income of consumer
what is international trade
Kwame Reply
international trade is a trade between foreign country
it is the exchange of goods and services between countries
it's the exchange of goods and services from one foreign country to another
how is demand run
Ogonna Reply
what s the causes of poverty for human being
Femi Reply
lack of knowledge and resources
it is lack of inclusive political and economic institutions in that country given a strong central government.
luck of economics
poverty is due to poor system of taxation
progressive system of taxation can reduce poverty
lack of knowledge
Isn't it poor system of taxation that causes poverty

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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