We now turn to the most important conclusion of Keynesian analysis. Keynes was the first prominent mainstream economist to argue (a) that "demand creates its own supply," and (b) that "sticky" adjustments of wages, prices, and interest rates might stall an economy in a semi-permanent "short-run" equilibrium at less than full employment. Keynes' ideas departed sharply from those of classical economists, who counted on flexible prices, wages, and interest rates to quickly counter any deviations from full employment. The severity of the Great Depression signaled that "invisible hand" mechanisms may operate only slowly at times. High cyclical unemployment showed few signs of automatic cure prior to World War II.
Potential GDP and full-employment GDP (or income) are rough synonyms.
Potential GDP is an estimate of what the economy could produce at high rates of utilization of our available resources, especially full employment of labor.
Estimates of potential GDP reflect trends in productivity, the size and composition of the labor force, and other influences on our capacity to produce.Estimates of the ratio of actual GDP to potential GDP for 1929–1993 are illustrated in Figure 8.
FIGURE 8 The Ratio of Actual GDP to Potential GDP, 1929–1993
Actual and potential GDP can diverge substantially. Since World War II their differences have been relatively minor. Nevertheless, recessions remain costly whether measured by lost income or by social trauma.
Sources: Economic Report of the President, 1994; Robert J. Gordon, Macroeconomics (New York: HarperCollins, 199X?). Updated by authors.
Potential GDP is not an absolute limit on productive capacity in the same way a production possibilities frontier is. For example, potential GDP might be exceeded through slavery, or if people who would normally choose not to work took temporary jobs to support a national defense effort (e.g., women during World War II), or if frictional unemployment artificially fell because many jobless workers accepted positions which, because of inflation, ultimately paid less than they expected. Ideally, potential GDP reflects only activities that are informed and voluntary, a point addressed in more depth later in this book.
The GDP Gap
Figure 8 illustrates that National Output can fall far below potential GDP.
The GDP gap is the difference between potential and actual GDP.
In the simple Keynesian model from Table 1 now graphed in Figure 9, equilibrium income is $7 trillion at point a, where expenditure curve AE0 intersects the 45o Y = C + S line. If potential GDP at full employment is $7.5 trillion, then a GDP gap of $500 billion exists. Would market pressures quickly move the economy above its original $7 trillion equilibrium? The Keynesian response is No. How might this $500 billion GDP gap be filled to achieve full employment income and output of $7.5 trillion? The Keynesian answer is to boost Aggregate Spending from AE0 to AE1. But by how much must autonomous spending be increased?
FIGURE 9 Recessionary and Inflationary Gaps
If full employment income is $7.5 trillion, but Aggregate Expenditures are only AE0, the equilibrium at point a ($7 trillion) falls below full employment. A GDP gap of $500 billion exists. Given our multiplier of 5, the recessionary gap is $100 billion (the vertical rise in autonomous spending needed for a full employment equilibrium).
If Aggregate Expenditures were AE2, excessive autonomous spending would yield an inflationary gap of $100 billion, with a negative GDP gap of -$500 billion. Although equilibrium (point b) is $8 trillion, the economy could not produce this much extra real output, so the price level would rise by 8/7.5.
Only at Aggregate Expenditures of AE1 will full employment and a stable price level be compatible.
The Recessionary Gap
Given that the multiplier in our example is 5 (1/0.2 = 1/mps), an increase in autonomous investment spending of $100 billion will raise Aggregate Spending and output by $500 billion, filling the GDP gap so that full employment is achieved.
The recessionary gap measures the amount by which autonomous spending falls short of that needed to bring equilibrium income to full employment.
The recessionary gap is measured along the vertical axis in Figure 9. Thus, the recessionary gap is defined by any shortfall in autonomous spending, not by the amount by which equilibrium income falls short of full employment income (measured along the horizontal axis).
GDP gap = recessionary gap ¢ multiplier
Any shortfall in equilibrium income is a GDP gap, and equals the recessionary gap times the autonomous spending multiplier.
The Inflationary Gap
What happens if autonomous spending is excessive?
An inflationary gap is the amount by which autonomous spending exceeds that needed to achieve full employment equilibrium.
The inflationary gap is the vertical distance between AE1 and AE2 in Figure 9, which equals $100 billion. Equilibrium at point b yields $8 trillion in income, but only $7.5 trillion can be produced at full employment, so this added demand drives prices upward because of increased competition among potential buyers. (Inflation is likely to be 6.7 percent ... 8/7.5 = 1.067.)