Cambridge International as and a level Economics Ebook

defl ationary gap
. 
Figure 9.24 
shows that the lack of 
aggregate expenditure results in an equilibrium level of 
GDP of 
Y
, below the full employment level of 
X
. Th
ere is a 
defl ationary gap of vw.
Deflationary gap: 
a shortage of aggregate expenditure so 
that potential output is not reached (equivalent to a negative 
output gap).
KEY TERM
0
Aggregate expenditure
Money GDP
EX 
= 
Y 
X
Y
C + I + G + 
(
X – M
)
 
45
°
a
b
Figure 9.22 
An inflationary gap
0
Aggregate expenditure
Money GDP
EX 
= 
Y 
X
Y
C + I + G
1
 + 
(
X – M
)
45
°
C + I + G + 
(
X – M
)
 
Figure 9.23 
Impact of a cut in government spending
Figure 9.24 
A deflationary gap
0
Aggregate expenditure
Money GDP
EX 
= 
Y
Y
X
C + I + G + 
(
X – M
)
45
°
v
w
Figure 9.25 
Impact of an increase in government spending
0
Aggregate expenditure
Money GDP
EX 
= 
Y
Y
X
C + I + G + 
(
X – M
)
45
°
C + I + G
1
 + 
(
X – M
)
Autonomous investment: 
investment that is made 
independent of income.
KEY TERM
251
Chapter 9: The macroeconomy 

---

As a result of an increase in investment from 
I
to 
I
1
, GDP 
rises by a multiple amount from 
Y
to 
Y
1
.
In contrast to autonomous investment, 
induced 
investment
is illustrated by a movement along the 
expen diture line. Th
is is because induced investment is 
invest ment that is infl uenced by changes in income. If 
income and hence demand increases, fi rms will be likely 
to buy more capital equipment. However, they will only 
continue to add to their capital stock if GDP continues 
to rise.
Induced investment: 
investment that is made in response 
to changes in income.
KEY TERM
The accelerator
Th
e
 accelerator theory
focuses on induced investment 
and emphasises the volatility of investment. It states that 
investment depends on the rate of changes in income 
(and hence consumer demand), and that a change 
in GDP will cause a greater proportionate change in 
investment. If a $1 million increase in GDP causes 
induced investment to rise by $3 million, the accelerator 
coeffi
cient is said to be 3.
If GDP is rising, but at a constant rate, induced 
investment will not change. Th
is is because fi rms can 
continue to buy the same number of machines each year 
to expand capacity. However, a change in the rate of 
growth of income can have a very signifi cant infl uence on 
investment.
Table 9.9
 provides an example. It is assumed that 
the fi rm starts the period with eight machines, that one 
machine wears out each year and that each machine can 
produce 100 units of output per year.
The table shows that when demand for consumer 
goods rises by 25% (from 800 to 1,000) in the second 
year, demand for capital goods rises by 200% (from 
1 to 3). When the rate of growth of demand for 
consumer goods slows in year 4, demand for capital 
goods falls, investment falls to zero with the worn-out 
machine not being replaced, and hence production 
capacity is reduced.
However, an increase in demand for consumer goods 
does not always result in a greater percentage change in 
demand for capital goods. For instance, fi rms will not 
buy more capital goods if they have spare capacity or if 
they do not expect the rise in consumer demand to last. 
It may also not be possible for fi rms to buy many capital 
goods if the capital goods industries are working close to 
capacity. In addition, with advances in technology, the 
Figure 9.26 
An increase in autonomous investment
0
Aggregate expenditure
Money GDP
EX 
= 
Y 
Y
Y
1
C + I + G + 
(
X – M
)
 
45
°
C + I
1
 + G + 
(
X – M
)