Question

Use the aggregate expenditures model to show how government fiscal policy could eliminate either a recessionary expenditure gap or an inflationary expenditure gap (Figure 11.7). Explain how equal-size increases in G and T could eliminate a recessionary gap and how equal-size decreases in G and T could eliminate an inflationary gap.

Short answer

The fiscal policy tools like taxes and government spending directly influence aggregate expenditure, which are used to eliminate any recessionary or inflationary expenditure gap.

An equal size increase in tax will reduce the recessionary expenditure gap in a lesser amount than government expenditure because the government spending multiplier is larger than the tax multiplier.

A decrease in government spending will decrease the inflationary expenditure gap more than that by an equal increase in taxes because of the difference in the two multipliers.

Step-by-step solution

Government fiscal policy for recessionary and inflationary expenditure gap

When the economic output falls short of the potential GDP due to recession, it creates a recessionary expenditure gap. A recessionary expenditure gap is a difference between the real output or aggregate expenditure at full employment and the actual aggregate expenditure.

In the above graph, AE_f represents the full employment aggregate expenditure at potential output Y_f. AE is the actual aggregate expenditure, and Y is the real output.The vertical distance between AE_f and AE is the recessionary expenditure gap.An increase in government spending and a decrease in taxes can increase the actual aggregate expenditure and lead to potential output.

On the contrary, the inflationary expenditure gap occurs when the economic output exceeds the potential GDP. Here, the aggregate output generates greater spending.

The above graph shows that the full employment level expenditure curve AEfresides below the actual aggregate expenditure curve AE. The vertical distance between the two expenditure curves is the inflationary expenditure curve. A decrease in government spending and increased taxes can reduce the actual aggregate expenditure and lead to potential output.

Fiscal policies can equate the aggregate expenditure to the potential output using the tools and eliminate any recessionary or inflationary expenditure gap.

Elimination of recessionary expenditure gap

An increase in G directly increases the initial aggregate spending.The initial increase leads to a larger shift because of the multiplier effect. The recessionary gap vanishes as the aggregate expenditure increases. It becomes equal to the real domestic output.

In contrast, reducing taxes in equal amounts (to G) will not increase the spending equally. The government multiplier effect produces a larger effect than taxes because the income increased by a reduction in taxes is not entirely consumed, but some part is also saved.

Elimination of inflationary expenditure gap

A reduction in government spending contracts the aggregate expenditure. An initial shrink in the spending results in a greater fall in the aggregate expenditure due to the multiplier effect. As aggregate expenditure falls and becomes equal to the potential output, eliminating the inflationary expenditure gap.

$△G=\frac{1}{1-MPC}$

On the other hand, an equal increase in taxes will reduce disposable income. However, the consumption expenditure will not fall in by the exact amount as income decreases because some decline will go to the saving side. It can be observed by the difference in the formulas of government spending multiplier and tax multiplier. The following formula represents the tax multiplier:

$△T=\frac{MPC}{1-MPC}$

Thus, an equal amount decrease in spending and increase in tax will not produce the same effect in reducing the inflationary expenditure gap.