Government and Fiscal Policy Flashcards
What can cause a deflationary gap?
If contractionary fiscal policy is not timely, targeted, and temporary, in the long run, it will cause a deflationary gap.
What is a deflationary gap?
A deflationary gap is the shortfall of national expenditure below national income.
There will be a negative output gap between the level of AD currently and the full-employment level.
Thus, the government needs to spend money, through expansionary fiscal policy to close the gap.
If the government spends that amount, Yf is reached and we are no longer in a recession.
Because of a deflationary gap, there will be excess capacity and under-utilisation of resources in the the economy. Thus, there is demand-deficient unemployment.
The deflationary gap is the amount that the expenditure curve is below the 45° line at the full-employment of national income.
How is a deflationary gap closed?
In this simple, Keynesian model, the cure for demand-deficient unemployment is to close the deflationary gap. An increase in AD is need - through the use of expansionary fiscal policy. This is achieved by increasing government expenditure, and decreasing taxes - so that consumers are able to consumer more goods and services. Loose monetary policy can also be implemented, where interest rates are decreased, so investment made by both firms and households is able to rise - therefore, increasing AD further.
This will cause an upward shift of the expenditure curve, until it reaches the 45° line at the full-employment level, and the deflationary gap will close.
What is an inflationary gap?
An inflationary gap is the excess of national expenditure over national income at the full-employment.
We are producing at a level which is more than the full-employment level due to inflation - there is a positive output gap between Yf and Ye.
The inflationary gap represents the amount by how much expenditure needs to be decreased by to at full employment as there is currently excess expenditure. At this point, machines as being over utilised and working are working over time.
What is needed to close an inflationary gap?
Contractionary fiscal policy is needed to reduce AD, thus closing the inflationary gap, and therefore eliminate demand-pull inflation.
