151 Recessionary and Inflationary Gaps in the Income-Expenditure Model (136/108) -- Macroeconomics

151 Recessionary and Inflationary Gaps in the Income-Expenditure Model Learning Objectives - Define potential real GDP and be able to draw and explain the potential GDP line - Identify appropriate Keynesian policies in response to recessionary and inflationary gaps The Potential GDP Line Figure 1 shows a Keynesian cross diagram with one additional feature: the potential GDP line. This feature is a vertical line showing potential real GDP. That is, we know GDP increases from left to right on the graph. At some point we reach potential GDP, and that’s what the Line shows. Potential GDP means the same thing here that it means in the AD-AS diagrams: it refers to the quantity of output that the economy can produce with full employment of its labor and physical capital. At any level of GDP less than potential, usually we have less than full employment. If we measure the unemployment rate at potential GDP, we get the natural rate of unemployment, that we defined in our earlier discussion on unemployment and inflation. 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 at the natural rate–what we call full employment. But there is no guarantee that the equilibrium will occur at the potential GDP level of output. The equilibrium might be higher or lower. Figure 1(a) illustrates a situation where the aggregate expenditure line intersects the 45-degree line at point E0, 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 E0 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. 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 Keynesian response to a recessionary gap is for the government to reduce taxes or increase spending so that the aggregate expenditure function shifts up from AE0 to AE1. When this shift occurs, the new equilibrium E1 now occurs at potential GDP as shown in Figure 1(a). Conversely, Figure 1(b) shows a situation where the aggregate expenditur