11.8 Equilibrium versus Full-Employment GDP

What is equilibrium GDP?

The level of GDP where aggregate expenditures (AE) = total output. It’s where the AE curve intersects the 45° line.

What is full-employment GDP?

The level of GDP where all available labor and resources are fully used without causing inflation. It reflects the economy’s potential output

Can equilibrium GDP differ from full-employment GDP?

Yes. The AE model allows for equilibrium below or above full employment, leading to recessionary or inflationary gaps

What is a recessionary expenditure gap?

The amount by which AE at full-employment GDP falls short of what’s needed to reach full employment

What does a recessionary gap cause?

• Cyclical unemployment

• Negative GDP gap

• Underutilized resources

Example: If AE is $5B below full-employment AE and the multiplier is 4, what is the GDP gap?

5B x 4 = 20B GDP gap

How can government close a recessionary gap?

• Increase government spending by the gap amount

• Cut taxes so that MPC × tax cut = gap amount

If MPC = 0.75, how much should taxes be cut to close a $5B gap?

5B/0.75 = 6.67B tax cut

What is an inflationary expenditure gap?

The amount by which AE at full-employment GDP exceeds what’s needed to maintain full employment.

What does an inflationary gap cause?

• Demand-pull inflation

• Nominal GDP rises

• Real GDP cannot rise much beyond potential

Why can’t real GDP rise far above full employment?

Because labor and resources are already fully used. Excess demand pushes up prices, not output.

What is a key limitation of the AE model?

It assumes prices are sticky. As GDP nears full employment, prices become flexible and inflation rises

What happened during the COVID-19 recession (2020)?

• AE fell sharply due to drops in consumption and investment

• GDP fell from $510B to $490B

• Unemployment surged

• Government used stimulus (e.g., CARES Act) to boost AE and close the recessionary gap

What was the multiplier effect during COVID stimulus?

Large government spending (e.g., $2.2T CARES Act) aimed to multiply AE increases and restore GDP and employment.

What is the relationship between equilibrium GDP and full-employment GDP?

They do not have to be equal.

Keynes proposed what two different policies that a government might pursue to close a recessionary expenditure gap and achieve full employment?

• Decrease taxes

• Increase government spending

What is an inflationary expenditure gap?

The amount by which aggregate expenditures at the full-employment GDP exceed those required to achieve full-employment GDP

Which of the following is likely to occur when aggregate expenditures are so high that the equilibrium level of GDP is beyond the potential output?

• The economy is likely to produce either at potential or just above potential output.

• The economy is likely to experience demand-pull inflation.

• Nominal GDP is likely to increase, but real GDP is not likely to increase.