EQ: How Does a Recessionary Gap Close According to Keynesian Economic Theory?
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- Noah Willis
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1 Remember that a recessionary gap is a situation where is less than Natural. Natural can be shown on a graph with the s curve. If the intersects the angle line at a point to the left of where Natural intersects the angle line, then the economy is in a recessionary Here is our starting point: The needs to intersect the angle line at this point in order to close the recessionary gap and return the economy to Long-Run. Recessionary Gap needs to increase by $4 B Income ( in Trillions of $) On an aggregate market graph, the recessionary gap looks like this: Recessionary Gap
2 Keynesian Theory rejects the idea that wages will fall in the labor market, decrease production costs, and decrease. Keynesian Theory suggests that must increase in order to close a recessionary Increasing means increasing TE. Keynesian Theory also suggests that this increase will not happen automatically. Government leaders must intervene to spark the increase in s Increase in Investment, Gov t Spending, or Net Exports. The government needs to make a decision to encourage one of the following to increase: Investment Government Spending Net Exports But how much should it increase? To close the recessionary gap, must increase by $4 Billion. MPC is.75, which means: 1 1 The Keynesian Multiplier is 4 ( = = 4 ) So, 4 x (spending increase) = $4 Billion. Using algebra to solve, we find that the increase must be $1 Billion (4 x $1 Billion = $4 Billion) So, if Investment, Government Spending, or Net Exports increases by $1 Billion, then will increase by $4 Billion $1 B Recessionary Gap Closed Income ( in Trillions of $) Increase in TE
3 Increase in TE Increase in Right Shift in Curve Increase in Remember that an inflationary gap is a situation where is greater than Natural. Natural can be shown on a graph with the s curve. If the intersects the angle line at a point to the right of where Natural intersects the angle line, then the economy is in an inflationary Here is our starting point: The needs to intersect the angle line at this point in order to close the inflationary gap and return the economy to Long-Run. Inflationary Gap needs to decrease by $4 B Income ( in Trillions of $)
4 On an aggregate market graph, the inflationary gap looks like this: Inflationary Gap Unlike a recessionary gap, Keynesian Theory does not reject Classical Theory s prediction that wages will increase and move to the left to close an inflationary However, Keynesian Theory does suggest that an inflationary gap can close by a left shift of the curve in addition to a left shift of the curve. Decreasing means decreasing TE. Keynesian Theory also suggests that a decrease in will not happen automatically. Government leaders must intervene to initiate the decrease in s Decrease in Investment, Gov t Spending, or Net Exports. The government needs to make a decision to influence one of the following to decrease: Investment Government Spending Net Exports But how much should it decrease? To close the inflationary gap, must decrease by $4 Billion. MPC is.75, which means: 1 1 The Keynesian Multiplier is 4 ( = = 4 ) So, 4 x (spending decrease) = $4 Billion. Using algebra to solve, we find that the decrease must be $1 Billion (4 x $1 Billion = $4 Billion) So, if Investment, Government Spending, or Net Exports decreases by $1 Billion, then will decrease by $4 Billion. 1
5 $1 B Decrease in TE Inflationary Gap Closed Income ( in Trillions of $) Decrease in TE Decrease in Left Shift in Curve Decrease in EQ: How can Keynesian Theory be Used to Manage the Economy? During a recessionary gap, the government can increase aggregate spending: Directly by increasing Government Spending on things like building highways. Indirectly by providing businesses incentives to spend money on Investment. Increases in Investment or Government Spending will set off a chain reaction of Consumption spending that will increase TE and close the recessionary EQ: How can Keynesian Theory be Used to Manage the Economy? During an inflationary gap, the government can decrease aggregate spending: Directly by decreasing Government Spending. Indirectly by implementing restrictions on businesses to spend less on Investment. Decreases in Investment or Government Spending will set off a chain reaction that erodes Consumption spending that will decrease TE and close the inflationary
6 EQ: What are Problems with Using Keynesian Though Keynesian Theory seems logical, there are some huge problems that make it difficult to implement: We don t really know the MPC. It is a theoretical number, so economists never really know its exact value. Since the Keynesian Multiplier is based on MPC, we also never really know what the multiplier is. As a result, overestimating or underestimating MPC and the Keynesian Multiplier can create problems in the economy. EQ: What are Problems with Using Keynesian Overestimating MPC: Changes in Investment and Government Spending will not have as strong of an effect as expected and recessionary/inflationary gaps will not fully close. Underestimating MPC: Changes in Investment and Government Spending will have stronger effects than expected and: A recessionary gap will close, then cause an inflationary An inflationary gap will close, then cause a recessionary EQ: What are Problems with Using Keynesian Though Keynesian Theory seems logical, there are some huge problems that make it difficult to implement: We don t really know Natural s value. We never really know if is higher than or lower than Natural because there is no objective measure of Natural we can only guess. Overestimating or underestimating Natural means that we will overestimate or underestimate the size of recessionary and inflationary gaps. EQ: What are Problems with Using Keynesian Overestimating Natural : Recessionary gaps will be smaller than expected and stimulating the economy may cause an inflationary Inflationary gaps will be larger than expected and cooling off the economy may not fully close the Underestimating Natural : Recessionary gaps will be larger than expected and stimulating the economy may not fully close the Inflationary gaps will be smaller than expected and cooling off the economy may cause a recessionary
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