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Fiscal policy to address output gaps

AP.MACRO:
POL‑1 (EU)
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POL‑1.A (LO)
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POL‑1.A.1 (EK)
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POL‑1.A.2 (EK)
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POL‑1.A.3 (EK)
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POL‑1.A.4 (EK)
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POL‑1.A.5 (EK)
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POL‑1.A.6 (EK)
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POL‑1.A.7 (EK)
Fiscal policy can be used to close output gaps. Fiscal policy means using either taxes or government spending to stabilize the economy. Expansionary fiscal policy can close recessionary gaps (using either decreased taxes or increased spending) and contractionary fiscal policy can close inflationary gaps (using either increased taxes or decreased spending).

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  • duskpin tree style avatar for user kavana11023
    since the formula for tax multiplier is negative, is it an error that Sal got the answer of 400 billion without adding back the negative sign?
    (3 votes)
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  • duskpin ultimate style avatar for user Sophia Dasilva
    At , Sal says we need to shift the Aggregate Demand curve to the right. Why don't we just shift the SRAS to the right instead?
    (2 votes)
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  • piceratops ultimate style avatar for user Jonathon
    In comparing government spending vs. tax reduction, aren't you conveniently omitting the fact that the government has to tax the people to get the money to spend to begin with? If you factor that that in, you only get $100B impact vs. $400B impact from the tax reduction. Tax reduction has 4x the real impact in this example.
    (1 vote)
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    • ohnoes default style avatar for user Noah L.
      While most of government spending comes from federal income taxes, some of it also comes from corporate taxes and payroll taxes, as well as from other miscelanious sources. Tax reduction is a double edged sword, in some ways, as people can choose to save or spend whatever extra disposable income they get from the tax reduction. Lets say that the government institutes a large tax reduction to stimulate the economy. If the people in that economy chose to save more than they spend, then the tax reduction policy won't have the desired effect.
      Furthermore, regarding the impact of government spending compared to tax changes to address output gaps, the impact of government purchases is larger. Recall that the government spending multiplier is (1/(1-MPC)), and that the tax multiplier is (-MPC/(1-MPC)). Comparing the two multipliers, it is evident that government spending has a greater impact on output compared to tax changes. Since the MPC is always less than 1, the numerator in the tax multiplier will always be less than that of the government spending multiplier. This means that tax changes have a "watered down" impact on fiscal policy. The MPC in the numerator limits the magnitude of the fiscal policy shift caused by changes in tax policy. Yes, tax changes help, but the magnitude effect for changes in government spending are larger than that of taxes.
      So, while on paper, a $100B impact vs. $400B impact difference may seem significant, taxes don't usually have a larger effect.
      (3 votes)
  • blobby green style avatar for user Superdbz
    What does outcome gap mean?
    (1 vote)
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  • blobby green style avatar for user Ruth Friedman
    what is Fiscal policy, i didnt understand...
    (1 vote)
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Video transcript

- [Instructor] What we see here is an economy with an output gap. As you can see, the 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 talk about how there could be a self-adjustment mechanism in the long run, that because we are below full employment, folks who maybe, especially folks who wanna 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 two, and in that case, all of a sudden, we would be in a long run equilibrium where our equilibrium output is equal to our full employment output. But let's say 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 wanna do something about it. You wanna 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 make it clear. This is government spending. Or changing the amount of taxation. So, the theory is if the government spends more, that would increase total output and then the 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 gonna go into detail in this video, but monetary policy is messing with the money supply. If maybe 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/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 two. 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 "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 a regular multiplier, let me write it over here, a regular multiplier, a 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 one 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, a hundred dollars, depending on my marginal propensity to consume, if my marginal propensity to consume is less than one, which it typically is, I'm not gonna spend all that hundred dollars. I am going to spend some fraction of it, really the marginal propensity to consume times a hundred dollars. While if the government just goes out there and spends a hundred dollars, well, that hundred dollars got spent. And to see the impact, the difference in impact, let's go through it a little bit, let's do an example. Let's say a situation where the government, the government just spends $100 billion. So, the government wants to spend $100 billion. 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 times, you're gonna multiply it times the multiplier, one over one minus our marginal propensity to consume, 0.8, and so this is going to be equal to $100 billion, $100 billion divided by 0.2. Well, 0.2 is 1/5, so this is going to be the same thing as dividing by 1/5 or multiplying by five, so you're going to have an increase in output based on this very simple model of $500 billion. 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 taxes by $100 billion, and we're gonna assume the exact same marginal propensity to consume. Well, in that situation, what's our tax multiplier? And we're decreasing taxes, so that will offset this negative. So, the increase in the economy is going to be our 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 $500 billion, this part, times 0.8. And so, what is that going to be? Well, that is going to be equal to $400 billion. 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 will then spend 80 billion of that, and then the people who'd get that would spend 64 billion, on and on and on, so it eventually ends up being $500 billion. But 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 20 billion of it and spend the other 80 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.