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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

what is Price mechanism
Dhany Reply
introduction to economics
Uday Reply
welfare definition of economics
examine the wealth and welfare definitions of economics
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What do we mean by Asian tigers
Aeesha Reply
Dm me I will tell u
What is Average revenue
How are u doing
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it is a group of 4 countries named Singapore, South Korea, Taiwan and Hong Kong because their economies are growing very faster
what's a demand
Edward Reply
it is the quantity of commodities that consumers are willing and able to purchase at particular prices and at a given time
quantity of commodities dgat consumers are willing to pat at particular price
demand depends upon 2 things 1wish to buy 2 have purchasing power of that deserving commodity except any from both can't be said demand.
Demand is a various quantity of a commodities that a consumer is willing and able to buy at a particular price within a given period of time. All other things been equal.
State the law of demand
The desire to get something is called demand.
what is the use of something should pay for its opportunity foregone to indicate?
Random Reply
Why in monopoly does the firm maximize profits when its marginal revenue equals marginal cost
astrid Reply
different between economic n history
Falma Reply
If it is known that the base change of RM45 million, the statutory proposal ratio of 7 per cent, and the public cash holding ratio of 5 per cent, what is the proposed ratio of bank surplus to generate a total deposit of RM 300 million? 
Jeslyne Reply
In a single bank system, a bank can create a deposit when it receives a new deposit in cash. If a depositor puts a cash deposit of RM10,000 into the bank, assume the statutory reserve requirement is 7% and the bank adopts a surplus reserve of 8%. a. Calculate the amount of deposits made at the end o
the part of marginal revenue product curve lies in the _ stage of production is called form demand curve for variable input.
Bashir Reply
The cost associated with the inputs owned by the farmer is termed as
the cost associated with inputs owned by the farmer is termed as ____
why do we study economic
Nwobodo Reply
we study economics to know how to manage our limited resources
we study economics the know how to use our resources and where to put it
what is end
we study economics to make rational decision
we study economics only to know how to effectively and efficiently allocate our limited resource in other to meet our unlimited wants
We study economics inorder for us to know the difference of the needs and wants and aslo how to use the limited resources that are available
who is the father of economy
Yajanyi Reply
adam smith
Adam smith
professor Lionel Robins
adam smith
mariginal utility is finalized by who?
Adam Smith
Adam smith
Adam Smith
Adam smith
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why we study economics
Kitojo Reply
what is equilibrium price?
This is the price In which quantity demanded is equal to the quantity supplied.
what is the principle of demand
is when the price of two item is equal
is the market price at which the demand curve and supply curve of particular commodity interest.
can we say that without macroeconomics,microeconomics can succeed? and why?
equilibrium price is when prices are equal
equilibrium price is a point at which demand and supply curve meet
please can you give us the correct answer after the lesson to be compared to our answers
Gloria Reply
in what?
why economics is the real life subject
because it is subjected to human decisions
why might an increase in money national income not necssarily lead to an increase in the standards of living
pls,who is a legal tender.can you explain well
Mary Reply
We think, that the legal tender is a form of payment of a debt or anything related, but which is not necessarily money. that can be bank notes, or coins for instance. but the bottom line is the legal tender is required to be recognized by the law, but it varies according to the jurisdiction.
Is it something like cheque
legal tender is anything that can be accepted for payment within a country
is Something legally accepted in a particular place

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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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