Fiscal Policy, Inflationary & Deflationary Gaps
Fiscal Policy, Inflationary & Deflationary Gaps
Fiscal Policy, Inflationary & Deflationary Gaps
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-3
Putting Fiscal Policy into
Perspective
• There was no such thing as fiscal
policy until John Maynard Keynes
invented it in the 1930s
– He maintained that
• The only way out of the Depression was to
boost aggregate demand by increasing
government spending
• If we ran a big enough budget deficit, we could
jump-start the economy and, in effect, spend
our way out of the depression
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-4
Putting Fiscal Policy into
Perspective
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-5
Putting Fiscal Policy into Perspective
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-6
The Deflationary Gap and
the Inflationary Gap
• Equilibrium GDP is the level of
output at which aggregate demand
equals aggregate supply
– Aggregate demand is the sum of all
expenditures for goods and services
(that is, C + I + G + Xn)
– Aggregate supply is the nation’s total
output of final goods and services
– So at equilibrium GDP, everything
produced is sold
12-7
The Deflationary Gap and the
Inflationary Gap
• Full-employment GDP is the level of
spending necessary to provide full
employment of our resources
– If our plant and equipment is operating at
between 85 and 90% of capacity, that’s full
employment
12-8
The Deflationary Gap & the Inflationary Gap
1
2
$1 trillion 1 2 3 4 5 6 7 8 9
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The Deflationary Gap & the Inflationary Gap
The Inflationary Gap
than full-
1,500 Inflationary gap
employment GDP,
there is an
inflationary gap.
1,000
500
0
$200 trillion 500 1,000 1,500 2,000
Equilibrium GDP
Full-employment GDP
GDP (in trillions of dollars)
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-10
Cutting
Also increasing
Taxes will
Government
increase C or
Spending
I, causing
cananshift
upward
the
shift
aggregate
in the expenditure
Aggregate expenditure
up and close
andthe
closing
gap. the gap.
Deflationary Gap
C+I+G+Xn
Equilibrium
Full employment
Summary
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-12
Summary
• Equilibrium GDP is above the full-
employment GDP
– Spending is too high
– Results in an inflationary gap
• Too eliminate the inflationary gap, we cut G
and/or raise taxes
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-11