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natural for Keynes to focus on the case in which equi-
Potential librium falls short of full employment, leaving some
GDP 45 resources unemployed. Figure 7 illustrates this possi-
bility. A vertical line has been drawn at the level of
potential GDP, a number that depends on the kinds of
aggregate supply considerations discussed at length in
F
Chapter 7”and to which we will return in the next
Real Expenditure




C + I + G + (X “ IM)
chapter. Here, potential GDP is assumed to be $7,000
billion. We see that the C 1 I 1 G 1 (X 2 IM) curve
cuts the 45° line at point E, which corresponds to a
E
GDP(Y 5 $6,000 billion) below potential GDP. In this
B
case, the expenditure curve is too low to lead to full
Recessionary gap employment. Such a situation arose in the U.S. in 2008,
after the economy, hampered by a slump in housing
and a variety of financial problems, slowed down
abruptly late in 2007.
An equilibrium below potential GDP can arise
45°
when consumers or investors are unwilling to spend
6,000 7,000
at normal rates, when government spending is
Real GDP
low, when foreign demand is weak, or when the price
level is “too high.” Any of these events would depress
NOTE: Figures are in billions of dollars per year.




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Chapter 9 183
Demand-Side Equilibrium: Unemployment or Inflation?



the C 1 I 1 G 1 (X 2 IM) curve. Unemployment must then occur because not enough out-
put is demanded to keep the entire labor force at work.
The distance between the equilibrium level of output demanded and the full-employment
level of output (that is, potential GDP) is called the recessionary gap; it is shown by the The recessionary gap is
the amount by which the
horizontal distance from point E to point B in Figure 7. Although the figure is entirely hy-
equilibrium level of real GDP
pothetical, real-world gaps of precisely this sort were shown shaded in blue in Figure 2 of
falls short of potential GDP.
Chapter 6 (page 112). They have been a regular feature of U.S. economic history.
Figure 7 clearly shows that full employment can be reached by raising the total expen-
diture schedule to eliminate the recessionary gap. Specifically, the C 1 I 1 G 1 (X 2 IM)
line must move upward until it cuts the 45° line at point F. Can this happen without
government intervention? We know that a sufficiently large drop in the price level can do
the job. But is that a realistic prospect? We will return to this question in the next chapter,
after we bring the supply side into the picture, for we cannot discuss price determination
without bringing in both supply and demand. First, however, let us briefly consider the
F I GU R E 8
other case”when equilibrium GDP exceeds full employment.
An Inflationary Gap
Figure 8 illustrates this possibility, which many peo-
ple believe characterized the U.S. economy in 2006 and
into 2007, when the unemployment rate dipped below
5 percent. Now the expenditure schedule intersects the Potential 45
GDP
45° line at point E, where GDP is $8,000 billion. But this
Inflationary gap
exceeds the full-employment level, Y 5 $7,000 billion.
E
B
A case such as this can arise when consumer or invest-
ment spending is unusually buoyant, when foreign C + I + G + (X “ IM)
Real Expenditure




demand is particularly strong, when the government
spends too much, or when a “low” price level pushes
the C 1 I 1 G 1 (X 2 IM) curve upward.
To reach an equilibrium at full employment, the F
price level would have to rise enough to drive the ex-
penditure schedule down until it passed through
point F. The horizontal distance BE”which indicates
the amount by which the quantity of GDP demanded
exceeds potential GDP”is now called the inflationary
gap. If there is an inflationary gap, a higher price level
45°
or some other means of reducing total expenditure is
7,000 8,000
necessary to reach an equilibrium at full employment.
Real GDP
Rising prices will eventually pull the C 1 I 1 G 1
(X 2 IM) line down until it passes through point F.
NOTE: Figures are in billions of dollars per year.
Real-world inflationary gaps were shown shaded in
The inflationary gap is
pink-color in Figure 2 of Chapter 6 (page 112). In sum:
the amount by which equi-
Only if the price level and spending plans are “just right” will the expenditure curve in- librium real GDP exceeds
tersect the 45° line precisely at full employment, so that neither a recessionary gap nor the full-employment level
an inflationary gap occurs. of GDP.

Are there reasons to expect this outcome? Does the economy have a self-correcting
mechanism that automatically eliminates recessionary or inflationary gaps and propels it
toward full employment? And why do inflation and unemployment sometimes rise or fall
together? We are not ready to answer these questions yet because we have not yet brought
aggregate supply into the picture. However, it is not too early to get an idea about why
things can go wrong during a recession.


THE COORDINATION OF SAVING AND INVESTMENT
To do so, it is useful to pose the following question: Must the full-employment level of
GDP be a demand-side equilibrium? Decades ago, economists thought the answer was
“yes.” Since Keynes, most economists believe the answer is “not necessarily.”



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Licensed to:
Part 2
184 The Macroeconomy: Aggregate Supply and Demand



To help us see why, Figure 9 offers a simplified
F I GU R E 9
circular flow diagram that ignores exports, im-
A Simplified Circular Flow
ports, and the government. In this version, income
Expenditures can “leak out” of the circular flow only at point 1,
Financial System where consumers save some of their income. Simi-
C+l
(I)
)
C
n( larly, lost spending can be replaced only at point 2,
t
io en
pt
tm
2
um where investment enters the circular flow.
S av




es
ns




Inv
Co
in g




What happens if firms produce exactly the
(S




full-employment level of GDP at point 3 in the
)




Investors
diagram? Will this income level be maintained as
we move around the circle, or will it shrink or



C+I
grow? The answer is that full-employment in-
Consumers
1
come will be maintained only if the spending by
investors at point 2 exactly balances the saving
done by consumers at point 1. In other words:
The economy will reach an equilibrium at full
Firms
employment on the demand side only if the
3 (produce the
amount that consumers wish to save out of
domestic product)
their full-employment incomes happens to
equal the amount that investors want to in-
Y
vest. If these two magnitudes are unequal, full
Income employment will not be an equilibrium.


Thus, the basic answer to the puzzle we posed at the start of this chapter is
The market will permit unemployment when total spending is too low to employ the
entire labor force.
Now, how can that occur? The circular flow diagram shows that if saving exceeds invest-
ment at full employment, the total demand received by firms at point 3 will fall short of total
output because the added investment spending will not be enough to replace the leakage to
saving. With demand inadequate to support production at full employment, GDP must fall
below potential. There will be a recessionary gap. Conversely, if investment exceeds saving
when the economy is at full employment, then total demand will exceed potential GDP and
production will rise above the full-employment level. There will be an inflationary gap.
Now, this discussion does nothing but restate what we already know in different
words.3 But these words provide the key to understanding why the economy sometimes
finds itself stuck above or below full employment, for the people who invest are not the same
A coordination failure
as the people who save. In a modern capitalist economy, investing is done by one group of
occurs when party A would
like to change his behavior individuals (primarily corporate executives and home buyers), whereas saving is done by
if party B would change another group.4 It is easy to imagine that their plans may not be well coordinated. If they
hers, and vice versa, and
are not, we have just seen how either unemployment or inflation can occur.
yet the two changes do not
Neither of these problems would arise if the acts of saving and investing were perfectly
take place because the de-
coordinated. While perfection is never attainable, the analysis in the accompanying box,
cisions of A and B are not
“Unemployment and Inflation as Coordination Failures,” raises a tantalizing possibility. If
coordinated.
both high unemployment and high inflation arise from coordination failures, might the
government be able to do something about this problem? Keynes suggested that it could,
by using its powers over monetary and fiscal policy. His ideas, which constitute one of our
Ideas for Beyond the Final Exam, will be examined in detail in later chapters. But even the
IDEAS FOR
simple football analogy described in the box reminds us that a central authority may not
BEYOND THE
FINAL EXAM find it easy to solve a coordination problem.

In symbols, our equilibrium condition without government or foreign trade is Y 5 C 1 I. If we note that Y is
3

also the sum of consumption plus saving, Y 5 C 1 S, then it follows that C 1 S 5 C 1 I, or S 5 I, is a restatement
of the equilibrium condition.
In a modern economy, not only do households save but businesses also save in the form of retained earnings.
4

Nonetheless, households are the ultimate source of the saving needed to finance investment.




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Licensed to:

Chapter 9 185
Demand-Side Equilibrium: Unemployment or Inflation?




Unemployment and Inflation as Coordination Failures
The idea that unemployment stems from a lack of coordination
between the decisions of savers and investors may seem abstract.
But we encounter coordination failures in the real world quite fre-
quently. The following familiar example may bring the idea down
to earth.

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