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The Inflationary Gap

Although Keynes devoted most of his efforts to studying unemployment, the Keynesian framework can also be used to explain inflation. Referring to Exh. 10, let's assume that (C + I )1 is the existing planned expenditure function and that the prevailing level of equilibrium GDP is $800 billion. Recalling that the full-employment output is $700 billion, you will recognize that our hypothetical economy now faces a different problem: inflation.

EXHIBIT 10. The Inflationary Gap

The Inflationary Gap

If $700 billion is the full-employment output, the economy cannot provide more than $700 billion worth of goods and services. In the Keynesian model, full employment implies that the economy is operating at full capacity, that it is not capable of producing any more output. If consumers and investors attempt to purchase more output than the economy is capable of producing, higher prices result as prospective buyers bid against one another. Real GDP, however, will not increase.

In this simple model, prices are assumed to be constant until full employment is reached. So long as there are unemployed resources, any increase in spending is translated into an increase in output and employment. Once full employment is reached, however, further output increases become impossible. From this point on, increases in spending cannot increase real GDP; they can increase only money GDP. The difference between a GDP of $700 billion and a GDP of $800 billion is not that the larger figure represents more output, but simply that higher prices are being paid for the full-employment output.[1]

The amount by which the equilibrium GDP exceeds full-employment, or potential, GDP is the inflationary gap. In this instance, the inflationary gap is equal to $100 billion, the difference between the full-employment output of $700 billion and the actual output of $800 billion. If inflation is to be eliminated without sacrificing full employment, the level of planned spending must be reduced so that the total expenditure function intersects the 45-de-gree line at $700 billion. The expenditure function (C + I )2 would give such an intersection. Because the multiplier in our hypothetical economy is 4, a $25 billion decrease in planned expenditures would reduce equilibrium GDP by $100 billion, eliminating inflation while still maintaining full employment.

As you can see, the Keynesian model suggests that a market economy does not always come to rest at a full-employment equilibrium. Instead, the equilibrium output may be consistent with unemployment or inflation. The appendix to this chapter will add government spending and taxation to the total expenditure model and will consider how the government's spending and taxing powers can be used to combat unemployment or inflation. Chapter 12 will repeat parts of this discussion in the context of the aggregate demand-aggregate supply model and will consider the impact of the government's spending and taxing decisions on the federal deficit and the public debt.

  • [1] In reality, increases in total expenditures or aggregate demand lead to increased output and higher prices even before full employment is reached. This possibility is illustrated in the aggregate demand-aggregate supply model, as presented in Chapter 11.
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