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EQUILIBRIUM WITH UNEMPLOYMENT OR INFLATION

Now that we know how the equilibrium output is determined, we want to consider the desirability—from the standpoint of full employment and price stability—of a particular equilibrium GDP. We want to know whether a particular equilibrium is consistent with full employment, unemployment, or inflation.

The Recessionary Gap

A major conclusion of the Keynesian revolution is that a capitalist economy can be in equilibrium at less than full employment. Consider the economy represented in Exh. 9. Let's assume that (C + I)j represents the economy's total expenditure function and that the existing level of equilibrium GDP is $600 billion. Let's make the additional assumption that $700 billion is the full-employment output—the level of output that allows us to achieve our target rate of unemployment. (Recall that our target rate of unemployment is higher than zero because a certain amount of frictional and structural unemployment is unavoidable, even in the best of times.) Given these assumptions, it is obvious that our hypothetical economy is in equilibrium at less than full employment.

EXHIBIT 9. The Recessionary Gap

The Recessionary Gap

This situation can be described as a recession—a period of weak economic activity and relatively high unemployment. The amount by which the equilibrium GDP falls short of full-employment, or potential, GDP is known as the recessionary gap. In this instance, the recessionary gap is equal to $100 billion, the difference between the full-employment output of $700 billion and the equilibrium output of $600 billion.

What causes a recession? The problem, in Keynesian terms, is too little spending. If full employment is to be achieved, the level of planned spending must be increased so that the total expenditure function intersects the 45-degree line at $700 billion. You can see that a function such as (C + I )2 would give such an intersection. With a multiplier of 4, a $25 billion increase in planned expenditure would be sufficient to increase output by $100 billion and bring about full employment.

 
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