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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

how environment affect demand and supply of commodity ?
Amos Reply
Wht at the criteria for market ?
Amos
what is difference between monitory policy and fiscal policy?
Malik Reply
monetary policy is a policy thrust by National Govt(CBN) to influence government spending, purchase &taxes
Frank
necessity of economics
Pamela Reply
I will say want,choice,opportunity cost,scarcity,scale of preference
Alao
what is monopoly market.How price output are determined under monopoly market
bisham
b) Monopoly market is an impecfect market where s single firm having the innovation to produce a particular commodity.Prices are determined through output since there are no other competitive.
Frank
Monopoly market:firm has market power & does not respond to market price
Frank
Explain the process of price determination under perfect competition market with suitable diagram
bisham Reply
Price determination under perfect competition via this process :firms have no market power to influence price rather firms respond to market price.
Frank
price is different from demand- demand is amount of commodity
Effah Reply
demand is amount /quantity of commodity a potential buyer is willing to buy at a given price at market
Frank
demand is a desire of customer on commodity with the ability to pay it and willing to buy it at given price of commodity
Harika
demand is price of what
Faith Reply
show that shortrun average cost
Baby Reply
what is economics
Mbah Reply
what is money
Mbah
what is money
Mbah
Difine macro economics
agaba
money is a medium of exchange between goods and services,maybe inform of currency.
Wesonga
Economics is study of how human beings strive to satisfy numerous wants using limited available resources.
Wesonga
how do you find the maximum number of workers the firms should employ order to produce where there are increasing returns
Jane
what are implications of computing national income?.
agaba
pl
MUDASIRU
what is the formulae for calculating national income
MUDASIRU
it calculated by value added method
Praveen
classify the production units like agriculture, banking, transport etc
Praveen
money is anything that is generally acceptetable for human
Ogbaji
Estimate the net value added(NVA) at fixed cost by each industrial structure
Praveen
definition of unemployment
Adam Reply
what are the causes of unemployment?
Mbubi Reply
The main causes of unemployment are listed below. 1. Frictional unemployment 2. Cyclical unemployment 3. Structural unemployment
assani
We can also categorize the causes on a broader sense as: 1. Political and 2. Social cause As unemployeement root causes are embaded in this two.
Yonathan
would opportunity cost exist if there was no scarcity?
assani
yes just because the opportunity cost arose when there is Alternative to choose among the alternatives.
BADAMASIU
I am thinking that, if our resources were unlimited, then there wouldn't be any need to forgo some wants. Hence the inexistence if opportunity cost
assani
Politics
Job
politics has done what?
assani
consider time assani
Mary
I'm Emmanuel,...I taught the main cause is the change in gov't.
Emmanuel
...Lack of capital to set up a firm respectively
Emmanuel
🙈
Emmanuel
I would like to bring in Educational levels can also be the cause the cause of the problem respectively
Emmanuel
I think the main causes of unemployment is lack of INFRASTRUCTURAL DEVELOPMENT OVER POPULATION OVER DEPENDENT ON GOVERNMENT LACK OF SELF EMPOWERMENT...
ananti
lack of skills among the new generation is the serious issue.
Vishal
Where I come from , I don't see why education or personal aspects seem to do with unimployment, technically the motivation and eigerness in all works of live is there , dispite the cultural influence and physical bearriors;the thing we lacking is Government Support and open market ethics.
Joe
sorry about that-(repation). We have a over powering ethical political system that's displacing the marketing asspects of economy and causing large scale unemployment right across the board...
Joe
can someone Explain Expansionary Monetary Policy and Contractionary Monetary Policy Using one of the instrument of Monetary Policy? Please am kinda lost here?. ta
Emmanuel Reply
using a graph show the case of substitute and compliment goods
Ade Reply
can anyone give me a simple explanation to Five Sector Macroeconomics?
Emmanuel
Can someone please define what economics is
jason Reply
economics simply is a social science subject that study human behavior.
dajan
economics is a social science which studies human behaviour as a relationship between ends and scarce means that has alternative uses
Alao
Can someone please tell me how to calculate GDP
Emmanuel
emmanual kapal to calculate GDP (Gross Domestic Product) has three method in calculating it (1)income approach (2) expenditure approach (3) value added method
Alao
thanks Alae
Emmanuel
u are welcome
Alao
in basic terms economics is revered to as battery system, it date back to when Men sees the need to exchange sapless goods and produce to gain , either wealth , basic necessities or to establish trading ties for personal benefit or social asspects in terms of coexistence and continuity, future .
Joe
what is the law of demand
Berlinda Reply
keep other thing constant, when the price increases demand decrease when the price decreases demand increases of the commodity.
sj
all things being equal,quantity demanded decrease as price increase and increase as price decrease
Seth
there's practial joke to it ..." the higher the demand ; scarcity, increase in production and drop in quality"... quite the controversy - for example China vs Europe, United States and we are all boxed up in between somewhere...
Joe
Other thing remain constant the low price of commodity the high quantity of commodity and vice versa is true
Baraka
Explain Effective demand
Anita Reply
What is effective demand
Anita
like Modi is in demand...best example of effective demand
Pranav
Don't get you
Anita
Anita you mean you don't get me or who?
Onyeking
level of demand that represents a real intention to purchase by people with the means to pay
Pranav

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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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