If you're seeing this message, it means we're having trouble loading external resources on our website.

If you're behind a web filter, please make sure that the domains ***.kastatic.org** and ***.kasandbox.org** are unblocked.

Main content

Current time:0:00Total duration:6:56

AP.MACRO:

POL‑1 (EU)

, POL‑1.A (LO)

, POL‑1.A.1 (EK)

, POL‑1.A.2 (EK)

, POL‑1.A.3 (EK)

, POL‑1.A.4 (EK)

, POL‑1.A.5 (EK)

, POL‑1.A.6 (EK)

, POL‑1.A.7 (EK)

what we see here is an economy with an output gap as you can see there short-run equilibrium output is below our full employment output this is sometimes referred to as a recessionary output gap and in other videos we talked about how there could be a self adjustment mechanism in the long run that because we are below full employment folks when who maybe especially folks who want to get a job might say hey I'm willing to work for less and less and maybe our short-run aggregate supply curve shifts down over time and we get to a state something like this and in that case so this would be our short-run aggregate supply curve - and in that case all of a sudden we would be at a long-run equilibrium where where our equilibrium output is equal to our full employment output but let's say that that does not happen let's say we are in a world where for some reason we stay sticky with this negative output gap and you are the government and you want to do something about it you want to get back to full employment output well there's a couple of levers you have fiscal policy fiscal policy which is all about changing how much you spend so this would be government spending let me write make it clear this is government government spending or changing the amount of taxation so the theory is if the government spends more that would be that would increase total output and then other theory is if the government taxes less there's more money out in the economy and that could also increase total output and there's also monetary policy which we're not going to go into detail in this video but monetary policy is messing with the money supply if maybe if there's more money out there lower interest rates it might increase output and then the opposite could be true the other way but we are going to so let me just write this this is the money supply money supply slash interest rates interest rates and this would be the business of a central bank but we are going to focus on fiscal policy so as a government what we want to see happen is this aggregate demand curve shift to the right so we want it to get to a place like this we want our aggregate demand curve to shift to the right just like this so this would be aggregate demand - and how do we do that how do we get this shift right over here so that we get to our full employment output well there's two levers that we can think about as we just said government spending and Taxation now a big misconception is a lot of folks say well if I increase spending by a hundred billion dollars that's equivalent of reducing taxes by a hundred billion dollars but because there would be a hundred billion more dollars out there in the economy to increase output but you have to be very careful remember what we learned about multipliers and remember these are all very simple models but our regular multiplier let me write it over here our regular multiplier our regular multiplier is one over one minus the marginal propensity to consume while our tax multiplier tax multiplier is equal to so if you have an increase in taxes that would be the negative of the marginal propensity to consume over 1 minus the marginal propensity to consume the negative would be if you increase taxes that is going to have a negative total effect on spending and the reason why you have this marginal propensity to consume in the numerator is if I were to have my taxes reduced by say $100 depending on my marginal propensity to consume if my marginal propensity to consume is less than 1 which it typically is I'm not going to spend all that hundred dollars I am going to spend some fraction of it really the marginal propensity to consume times $100 while if the government just goes out there and spends $100 well that $100 got spent and to see the impact the difference in impact let's go through a little bit let's do it an example let's say a situation where the government the government just spends 100 billion dollars so the government wants to spend 100 billion dollars what is going to be the impact and let's say we're in a world where our marginal propensity to consume is equal to 0.8 what is going to be the effect on the economy in this situation right over here well in this situation you're going to have a hundred billion dollars of spending time you're going to multiply it times the multiplier 1 over 1 minus our marginal propensity to consume 0.8 and so this is going to be equal to 100 billion dollars one hundred billion dollars divided by 0.2 well 0.2 is one-fifth so this is going to be the same thing as dividing by one-fifth or multiplying by five so you're going to have an increase in output based on this very simple model of five hundred billion dollars so our multiplier here was five but let's say we go the other way let's say instead the government decides to decrease taxes by a hundred billion dollars so decrease decrease taxes by one hundred billion dollars and we're going to assume the exact same marginal propensity to consume well in that situation what's our tax multiplier and we're decreasing taxes so that'll offset this negative so the increase in the economy is going to be a hundred billion dollars times our marginal propensity to consume 0.8 divided by one minus the marginal propensity to consume well this part right over here was exactly the same as what we had over there so that's going to be equal to five hundred billion dollars this part times 0.8 and so what is that going to be well that's just going that is going to be equal to four hundred four hundred billion dollars and once again intuitively where did this come from well if the government spends that hundred billion dollars that hundred billion dollars gets spent and then you have the marginal propensity to consume the person or the people who get it would then spend eighty billion of that and the people who get that would spend sixty four billion on and on and on so it eventually ends up being five hundred billion but the with the decrease in taxes of a hundred billion that first hundred billion doesn't necessarily get spent if I get my taxes reduced let's say they're all on me by a hundred billion I might save some of it based on this marginal propensity to consume I might save twenty billion of it and spend the other eighty billion and so that's why based on this simplified model you might have a lower total impact right over here so that's a very important takeaway fiscal policy government spending or taxation but based on these models you would use a different multiplier and so they are not going to be necessarily equivalent

AP® is a registered trademark of the College Board, which has not reviewed this resource.