MPC, the Multiplier and Gaps

In this lesson, we will put together all of the pieces of the model. Remember, our goal is to reach
long run equilibrium. No gaps! Gaps occur when what is actually going on in the economy is different
from what it can do at full employment.

Think of yourself as a doctor, but instead of working on people you’re working on the economy.
Sometimes, the patient (the U.S. economy is anemic-not enough CIGX-which causes a recession.
Sometimes, the patient (the U.S. economy) is Hyperactive-too much activity-which causes inflation.

As the doctor, your training (the AD/AS Model) tells you that certain conditions call for a certain
treatment and that other conditions call for other treatments. The AD/AS model helps us to understand
the causal relationship between the ailment and the treatment. Note that I refer to a treatment and not a
cure. In the next three units, you will see whether the treatment works as the model indicates, whether
we are treating only the most immediate symptom such as the headache rather than the underlying sinus
infection, and whether the treatment is sometimes worse than the cure.

Let’s review the graphs!

Price LRAS SRAS Price LRAS

Level Level
SRAS

AD2 Pe
Pe
AD

AD AD2
Qe FE Real GDP FE Qe Real GDP

GDP Gap Negative GDP Gap

Inflationary Gap
Recessionary Gap

Ailment: Recession/Unemployment Ailment: Inflation

Treatment:: AD Treatment: AD

Medicine: CIGX Medicine: CIGX

Dosage? Determined by the multiplier which is Dosage? Determined by the multiplier which is
determined by the MPC/MPS determined by the MPC/MPS

Goal: Shift AD to the right until it intersects Goal: Shift AD to the left until it intersects SRAS
SRAS and LRAS at the same point, long run and LRAS at the same point, long run
equilibrium. Shown as the orange AD2 equilibrium. Shown as the orange AD2 curve.
curve.

Alternative medicine for both gaps: Shift SRAS. For the recessionary gap, shift SRAS to the
right. For the inflationary gap, shift SRAS to the left. However, at this point in the course, we are
taking the Keynesian view that AD is the key. In a later unit we will explore shifting SRAS to
correct economic problems.

Dilemma: What do we prescribe when unemployment and inflation are rising together? When we
shift AD, we make one problem better and one problem worse. What do we do when both are
worsening at the same time?

This is called stagflation. It cannot be treated by simply shifting AD. If we shift AD to the right, we
lower the unemployment but worsen the inflation. If we shift AD to the left, we lower inflation but
worsen unemployment. Typically, stagflation has been caused by an exogenous or external
shock to the economy. In the 1970’s oil prices soared because OPEC cut production. Oil is a
critical resource and its rising price caused production costs to rise which caused AS to shift to
the left. Thus, the treatment may be to shift AS to the right. We will see later that AS will probably
shift to the right on its own given time. But for this unit, let’s practice shifting AS to the right by
changing one of the determinants such as developing new technology, increasing government
subsidies, decreasing taxes and regulations, or finding new resources.

Here’s how stagflation is graphed.

SRAS2
Price
Level SRAS1
P2

P1

AD

Q2 Q1 Real GDP

When AS shifts from SRAS1 to SRAS2, price level rises and unemployment rises. Shifting AD to
the right or left will not correct both problems at the same time. Rather, AS needs to shift back to
SRAS1.
Return to the unit notes and lesson #1 and review the MPC, MPS and the multiplier. Once you are
comfortable with them, answer the questions below in a MS Word document. Upload your
answers into the dropbox. Be sure to fully identify your document with your name and unit/lesson
number.

SHOW ALL YOUR WORK-EACH STEP!

Level
1. SRAS
Price LRAS SRAS
Level
Pe

AD

Pe
FE Qe Real GDP
300 475
AD
Qe FE Real GDP
500 650
a. Identify and label the gap(s). Identify the
a. Identify and label the gap(s). Identify the major economic problem.
major economic problem.
b. Would you recommend increasing or
b. Would you recommend increasing or decreasing AD? Should CIGX increase or
decreasing AD? Should CIGX increase or decrease?
decrease?
c. If the MPC is .9, how much does CIGX have
c. If the MPC is .6, how much does CIGX have to change to close the GDP Gap?
to change to close the GDP Gap?
d. If the MPC is .7, how much does CIGX have
d. If the MPC is .75, how much does CIGX to change to close the GDP Gap?
have to change to close the GDP Gap?
e. If the MPS is .2, how much does CIGX have
e. If the MPS is .3, how much does CIGX have to change to close the GDP Gap?
to change to close the GDP Gap?
5. If there is an inflationary gap of $35 and if the
multiplier is 8, how much is being
2. If there is a recessionary gap of $20 and if overproduced?
the multiplier is 4, how big is the GDP gap?
6. If the Negative GDP Gap is $560 how much
3. If the GDP Gap is $320 how much is the is the inflationary gap if
recessionary gap if
a. the MPC is .6
a. the MPC is .6
b. the MPC is .75
b. the MPC is .75
c. the MPS is .3
c. the MPS is .3

4. Price LRAS
7. Graph a recessionary gap and then show
what direction AD shifts to correct the gap.

8. Graph an inflationary gap and then show

what direction AD shifts to correct the gap.

9. What is the difference between changing

Consumption versus changing Investment in
closing a gap?

10. Graph stagflation. Evaluate shifting AD

versus shifting AS in response to stagflation.