An Inflationary Gap

Here is an example of an inflationary or expansionary gap. For this example, assume:

Y= 2500*3.33 - 500*2.33 = 7167.

But (we now suppose) the government determines that even at "full employment" the economy can produce no more than 6000. They believe this expansionary gap is the cause of the inflation the country is experiencing. They want to adopt contractionary policies to reduce equilibrium production to 6000, in the hope that this will prevent further inflation.

(Policies that prevent further inflation, but do not attempt to return the price level to a lower level than at present, are called "disinflation." Thus we could say that the government wants to adopt contractionary policies in order to disinflate).

Here are two policies that could meet that target:

Cut government purchases by 350.

Since the autonomous spending multiplier is 3.33 in this model, this policy would reduce equilibrium income by 350*3.33 = 1167. Thus, equilibrium production would be reduced from 7167 to 6000. The government would then run a budgetary surplus of 350.

Increase taxes by 500.

Since the tax multiplier is 2.33, this would reduce the equilibrium production by 500*2.33 = 1167 -- again, just enough to get equilibrium income down to the target of 6000. The government would then run a budgetary surplus of 500.

Cut transfer payments by 500.

We recall that transefer payments are an offset against taxes -- so this will work just like an increase in taxes: It would reduce the equilibrium production by 500*2.33 = 1167 leaving equilibrium income at 6000, and a government budgetary surplus of 500.

The Graphic View