The GDP Gap

The GDP gap is defined as the difference between potential GDP and real GDP. When the economy falls into recession, the GDP gap is positive, meaning the economy is operating at less than potential (and less than full employment). When the economy experiences an inflationary boom, the GDP gap is negative, meaning the economy is operating at greater than potential (and more than full employment).

Potential (light) and actual (bold) GDP estimates from the Congressional Budget Office. The difference between the two represents the GDP gap.

Since the neoclassical model assumes the economy operates at (exactly) full employment, the GDP Gap isn’t really relevant to Neoclassical analysis but it is integral to the Keynesian view of the world.

Keynesian Policy for Fighting Unemployment and Inflation

Keynesian macroeconomics argues that the solution to a recession is expansionary fiscal policy, such as tax cuts to stimulate consumption and investment, or direct increases in government spending that would shift the aggregate demand curve to the right. For example, if aggregate demand was originally at ADr in Figure 11.11, so that the economy was in recession, the appropriate policy would be for government to shift aggregate demand to the right from ADr to ADf, where the economy would be at potential GDP and full employment.

Keynes noted that while it would be nice if the government could spend additional money on housing, roads, and other amenities, he also argued that if the government could not agree on how to spend money in practical ways, then it could spend in impractical ways. For example, Keynes suggested building monuments, like a modern equivalent of the Egyptian pyramids. He proposed that the government could bury money underground, and let mining companies get started to dig the money up again. These suggestions were slightly tongue-in-cheek, but their purpose was to emphasize that a Great Depression is no time to quibble over the specifics of government spending programs and tax cuts when the goal should be to pump up aggregate demand by enough to lift the economy to potential GDP.

Figure 11.11. Fighting Recession and Inflation with Keynesian Policy If an economy is in recession, with an equilibrium at Er, then the Keynesian response would be to enact a policy to shift aggregate demand to the right from ADr toward ADf. If an economy is experiencing inflationary pressures with an equilibrium at Ei, then the Keynesian response would be to enact a policy response to shift aggregate demand to the left, from ADi toward ADf.

The other side of Keynesian policy occurs when the economy is operating above potential GDP. In this situation, unemployment is low, but inflationary rises in the price level are a concern. The Keynesian response would be contractionary fiscal policy, using tax increases or government spending cuts to shift AD to the left. The result would be downward pressure on the price level, but very little reduction in output or very little rise in unemployment. If aggregate demand was originally at ADi in Figure 11.11, so that the economy was experiencing inflationary rises in the price level, the appropriate policy would be for government to shift aggregate demand to the left, from ADi toward ADf, which reduces the pressure for a higher price level while the economy remains at full employment.

In the Keynesian economic model, too little aggregate demand brings unemployment and too much brings inflation. Thus, you can think of Keynesian economics as pursuing a “Goldilocks” level of aggregate demand: not too much, not too little, but looking for what is just right.

Self Check: The GDP Gap

Answer the question(s) below to see how well you understand the topics covered in the previous section. This short quiz does not count toward your grade in the class, and you can retake it an unlimited number of times.

You’ll have more success on the Self Check if you’ve completed the six Readings in this section.

Use this quiz to check your understanding and decide whether to (1) study the previous section further or (2) move on to the next section.