Using an appropriate diagram explain how a government may attempt to close a deflationary gap.

Keynesian 45° Diagram

In this diagram, we can see that the level of aggregate demand is lower than the level of output at full employment, therefore the economy is overproducing and a decline in growth will occur. For example, say the level of current aggregate demand is $500, and aggregate demand at full employment is $600. This means that the value of the deflation is $100, that is, people are spending $100 dollars less than they can technically afford to. This situation may also be shown in the real output diagram below.

The value of the deflationary gap is again $100. This is not good news for countries, as it means that the growth of their output will decrease, and standards of living associated may decline. In order to deal with this problem, governments may attempt to implement some sort of fiscal policy, which will attempt to increase aggregate demand, or GNP, back to the full employment level. A fiscal policy is a purposeful budget action designed to stimulate an economy and bring it out of a deflationary period. Fiscal policy may consist of government injections into an economy in money, or decreases in taxes that raise real income. An example of use of fiscal policy to recover from deflation of an economy is the massive public works projects that Japan funded in the mid 1990’s which stimulated the economy, and helped to move it out of a depression. One would think that this government spending would be reflected by an increase in taxes to fund such works, however, as in the case of Japan, the government may go into budget deficit to fund works, or may use money leftover from budgeting, called budget surplus.

The fact that a massive increase in government spending stimulates the economy is due to the multiplier effect. In essence, the multiplier shows how increases in planned injections into the economy lead to larger increases in output and income, and therefore GNP and AD rise. This is because an initial money injection sets off spending from other people. For example, a firm spends $200 million on a new warehouse. The firm would pay contractors to build the warehouse. This $200m paid to contractors would be an increase in aggregate demand. This contractor may then use the $200m to pay workers building the warehouse, which may spend $20m on food. Manufactures of food would then pay their workers, who would again spend on other goods. John Keynes argued this point in his 1936 book, and stated that every job directly created by increased spending by firms would indirectly create other jobs. The government spending, therefore, sets off rounds of spending and increases in employment of further value than the initial injection of funds. Decreases in taxes also have the same effect, as taxpayers now have more income which they may spend on goods and services, which in turn pay employees and NY increases due to the multiplier effect.

When considering how best to close an inflationary gap, the government must look at the size of the multiplier. That is, how large will the increase in National Income be in proportion to initial spending? The size of the multiplier is determined by the equation

        Size of multiplier =           1

     (1-mpc)

MPC is the marginal propensity to consume. This refers to the amount of an increase in autonomous (outside the economy) income is spent on domestic goods and services and how much is saved. When autonomous spending increases aggregate expenditure, the increase will increase household income. This income may leak out in the form of savings, taxes or spending on imports, but the rest will be spent on domestic goods and services. The opposite of marginal propensity to consume is marginal propensity to save, which refers to what proportion of an autonomous income increase will be saved as opposed to spent.

For example, if the MPC is 0.5 the multiplier will be 2, which means that an increase in government spending of $100 million will increase NY by $200 million. The multiplier effect and its use by governments to stimulate AD can be shown in the diagram below.