0.4 The expenditure-output model  (Page 9/16)

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. But there is no guarantee that the equilibrium will occur at the potential GDP level of output. The equilibrium might be higher or lower.

For example, [link] (a) illustrates a situation where the aggregate expenditure line intersects the 45-degree line at point E ₀ , 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 E ₀ 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.

Addressing recessionary and inflationary gaps

What might cause a recessionary gap? 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. Moreover, an economy that is at equilibrium with a recessionary gap may just stay there and suffer high unemployment for a long time; remember, the meaning of equilibrium is that there is no particular adjustment of prices or quantities in the economy to chase the recession away.

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 AE ₀ to AE ₁ . When this shift occurs, the new equilibrium E ₁ now occurs at potential GDP as shown in [link] (a).

Conversely, [link] (b) shows a situation where the aggregate expenditure schedule (AE ₀ ) intersects the 45-degree line above potential GDP. The gap between the level of real GDP at the equilibrium E ₀ and potential GDP is called an inflationary gap . The inflationary gap also requires a bit of interpreting. After all, a naïve reading of the Keynesian cross diagram might suggest that if the aggregate expenditure function is just pushed up high enough, real GDP can be as large as desired—even doubling or tripling the potential GDP level of the economy. This implication is clearly wrong. An economy faces some supply-side limits on how much it can produce at a given time with its existing quantities of workers, physical and human capital, technology, and market institutions.