Calculating the Size of an Expansionary Gap

Calculating the Size of an Expansionary Gap
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  • 0:07 Why Calculate the Size…
  • 1:50 How to Calculate the…
  • 4:31 Compare Actual Output…
  • 5:13 Subtract Actual Output…
  • 5:56 Inflation: The…
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

This lesson will teach you how to estimate the size of an expansionary gap by calculating the difference between actual economic output and potential economic output. The task of knowing the size of an expansionary gap is critical for economists and government leaders who want to attempt to eliminate it so they can help smooth out the business cycle.

Why Calculate the Size of an Expansionary Gap?

An increase in economic output and simultaneous decrease in unemployment creates an expansionary gap.
Economic Output and Unemployment

Throughout the business cycle, actual economic output is sometimes above its long-run potential. Like a long-distance runner who can only run so fast, our economy has a long-run potential. A long-distance runner can occasionally speed up for a little while and run faster than usual, but will usually slow back down to a normal pace. Our economy is no different. Economic output is occasionally higher than normal and unemployment lower than normal. When current economic output exceeds the economy's potential output, economists call this an expansionary gap. Sometimes it's called an inflationary gap because inflation is a common result of expansionary gaps.

You'll hear me talk about 'potential output' throughout this lesson. Potential output is the Real Gross Domestic Product (or Real GDP) that could have been produced by an economy if all the resources in the economy were fully employed.

For the rest of this lesson, we're going to take a look at how economists estimate the size of an expansionary gap. Why is this important? It's important because estimating the size of an expansionary gap is the first step in the process of eliminating that gap. The central bank attempts to eliminate expansionary gaps by using monetary policy that raises interest rates and brings inflation down.

How to Calculate the Size of an Expansionary Gap

How do they figure out how big an expansionary gap is? The size of the expansionary gap is the difference between actual and potential output, measured in terms of Real Gross Domestic Product - or Real GDP for short. Let's look at an example:

Graph of economic output
Calculating Expansionary Gap Graph

Above is a graph of economic output at some point in time. As you can see, there are three lines on the graph. The vertical black line is the Long Run Aggregate Supply, or LRAS for short. The red curve is the Short Run Aggregate Supply, or SRAS curve. The blue curved line represents Aggregate Demand, or AD for short. Just by looking at this graph, we can already tell that this economy has an actual output that's above its long-run potential, simply because the AD, or what people are willing and able to buy, intersects the SRAS, which is what producers are willing and able to sell, and this intersection is taking place to the right of the long-run potential (which is the vertical LRAS). This is the exact opposite of a contractionary gap, meaning that if this intersection took place on the left side of the LRAS, we'd be talking about a contractionary gap and how to measure that.

If you want to picture what an economy like this might look like, just think about walking down the street of a large metropolis and seeing every store filled with customers, extra workers running through the stores looking for extra products for customers, while the government unemployment office is filled with workers who are bored out of their minds reading newspapers and magazines and doing crossword puzzles because so few people are depending on unemployment checks.

Now, let's measure the size of this expansionary gap, which you can do for any example, if you just understand the process. Begin by looking at point b, then move straight downward on the graph until you reach the scale at the bottom. As you can see, it's $15 trillion on the scale of Real GDP. This is what we call 'actual output.' So, point b is what we call actual output.

Compare Actual Output with Potential Output

Now, take a look at point a, then move straight downward until you get to the scale at the bottom of the graph. Notice that point a corresponds to a Real GDP of $14 trillion. This is the economy's long-run potential that we talked about, and when you look at both of these things together, you realize that there is a difference, or a 'gap,' between them.

Economists would say it this way: Actual output is $15 trillion while potential output was $14 trillion, and that created a $1 trillion expansionary gap.

Subtract Actual Output from Potential Output

Calculating an expansionary gap is very simple and requires you to simply subtract the two numbers - subtract the economy's actual output from its long-run potential. In this case, it's $15 trillion minus $14 trillion, which equals $1 trillion. It's that easy. This skill remains the same, but you're going to see it with different numbers.

Calculating the size of another expansionary gap
Calculating Expansionary Gap Size

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