Holt 7525-9 S15_IT

Keynesian Fiscal Policy Theory and an Inflationary Gap
If the economy is in an inflationary gap, Real GDP is greater than Natural Real GDP. To close an
inflationary gap, Total Expenditures needs to decrease. A decrease in Total Expenditures can be
caused by contractionary fiscal policy (a decrease in government expenditures and/or an
increase in taxation). To close an inflationary gap, Keynesian theory calls for the use of
contractionary fiscal policy, which will alter the government’s budget situation. Assuming that the
budget is initially balanced, contractionary fiscal policy will create a budget surplus. Thus,
Keynesian theory calls for the use of budget surpluses to close an inflationary gap.
Example 2: If Real GDP is $19,000 billion and Natural Real GDP is $18,500 billion, the economy
is in an inflationary gap. If the MPC is .80, the multiplier will be 5. With a multiplier of 5, a
decrease in government purchases of $100 billion would cause an eventual decrease in Real
GDP of $500 billion. If Real GDP decreases by $500 billion, the inflationary gap is closed and
Real GDP equals Natural Real GDP. The graphs below illustrate the inflationary gap and the
return to Natural Real GDP triggered by the decrease in government purchases.
Price
Level
Price
Level
Inflationary Gap
Q N
$18500B $19000B
Real GDP
Return to Natural Real GDP
Q N
$18500B $19000B
Real GDP
SRAS
AD
SRAS
AD2 AD1
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9 - 3 Fiscal Policy