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## Fiscal policy

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

# Fiscal policy to address output gaps

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)

## 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.