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[MUSIC]

Let's pause briefly and assess where we are.

We get one curve, the consumption function, that slopes upward,

and its slope is flatter than the aggregate production curve.

We've also got two other curves that by Keynesian assumptions

are horizontal lines the investment and the government expenditure functions.

If we vertically sum these curves we arrive

at the aggregate expenditures function and the important point to note is that.

Because the investment in government expenditure

functions are both horizontal lines the slope

of the aggregate expenditures function would be

the same slope as the consumption function.

Of course we already know what that slope is a marginal propensity to consume,

this complete aggregate expenditures curve is illustrated in this figure,

in the figure the full employment output is $900 billion.

But the economy is stuck at a recessionary output of $800 billion where the

aggregate expenditures curve AE crosses the 45

degree line of the aggregate production curve AP.

Now in the Keynesian model expansionary

fiscal policy can be used to close this $100 billion recessionary gap.

But, before we can demonstrate this, we've got one more

concept we must master, the so called Keynesian expenditure multiplier.

The Keynesian expenditure multiplier, is the number by which a change in

aggregate expenditures, must be multiplied in order to determine the resulting change

in total output.

This multiplier is greater than 1 and the reason is that income

is re-spent, not just once but many times after the initial increase.

1:57

This figure shows how the multiplier process can deepen a recession.

Here we see that in step one, there is an

aggregate demand shock, which leads to $100 billion in unsold

goods from a reduction in aggregate demand.

In step two, this leads to a cutback in employment and wages.

While in step three, this leads to a reduction in income.

2:54

In the Keynesian model it can be

easily shown mathematically that the multiplier is simple

the reciprocal of the marginal propensity to save.

That is the multiplier is one divided by the MPS, or put another

way, one divided by one minus the marginal propensity to consume.

3:17

What then is the multiplier for the following use of the MPC?

0.5, 0.75, 0.8

and 0.9. This exhibit provides the multiplier

for MPC's of 0.5, 0.75, 0.8 and 0.9 while

illustrating the first five steps of the multiplier.

3:49

Now that we know how to calculate the multiplier let's put it to work.

Suppose then that the U.S. permanently increases defense spending by $100 billion

in response to a threat to the oil fields in the Middle East.

What will be the effect of this increase in G on the GDP?

4:10

This figure provides us with an answer. In the figure the increase in G shifts

upward the C+I+G line by $100 billion to C+I+G prime.

The new equilibrium level of GDP is thus read off the

forty-five degree line at E prime, rather than at E.

4:34

Because the MTC is two thirds, the multiplier is three,

and the new level of output is $300 billion higher.

From this example you can see now why the analogy of

using government expenditures to prime the economic pump is particularly apt.

Such expenditures trigger increased investment and consumption, and

the total expansionary effect is far larger than

the initial stimulus. It should also be clear from this example

how important the role of the multiplier is in the conduct of fiscal policy.

To reaffirm this point, let's go back to our earlier

example, where we faced a recessionary gap of $100 billion.

5:32

To answer this question, let's first calculate the multiplier.

It is simply 1 divided by 0.2, gives us a multiplier of 5.

Therefore, to close the $100 billion recessionary gap, we must increase

government spending by $20 billion, because 5 times 20 equals 100.

Now alternatively, we can

use a tax cut, instead of increased government

expenditures, to close this same $100 billion recessionary gap.

Fiscal policy move, much like was done in the 1960s with the famous Kennedy Tax Cut.

However, the calculation for the appropriate size for the tax cut

is a little more complicated than it is for government expenditures.

This is because a

dollar's worth of tax cuts has slightly less of

an expansionary effect than a dollar's increase in government expenditures.

The reason is that consumers will not increase their

expenditures by the full amount of the tax cut.

Instead they will save a portion of that

tax cut based on their marginal propensity to save.

7:07

Now let's put this tax multiplier concept to work.

How much should taxes be cut to close a $100 billion recessionary gap if we

retain the assumption that the marginal propensity to

consume is 8 and the multiplier is 5?

7:37

We arrive at this total by first multiplying the expenditure

multiplier of five times the MPC, yielding a tax multiplier of

four. Then, four times the $25 billion tax

cut yields the desired $100 billion expansion.

7:58

Well we now know how to use expansionary fiscal policy to close a recessionary gap.

Suppose we face an inflationary gap instead.

A gap, such as the one in the late 1960's, caused

by demand-pull inflation from the Vietnam War, and great society expenditures.

8:54

Now in light of these inflationary pressures, how might

fiscal policy be used, to close the inflationary gap?

In trying to answer this question, please offer a specific a solution as possible.

9:11

To close the inflationary gap, we must use contractionary fiscal policy.

Where, contractionary fiscal policy involves reduced government expenditures

Tax hikes, or some combination of the two, to cool inflationary pressures.

9:29

More specifically, from the figure, we see that

the slope of the aggregate expenditures curve is

75, so that we know that the multiplier is four.

Thus to close this inflation area gap we simply have to reduce government

expenditures by $15 billion or alternatively raise taxes by $20 billion.

At a multiplier of four either fiscal policy

tool will lead to the desired economic contraction

of $60 billion.

10:06

Now you might wonder at this point, whether it is more preferable

to increase government spending, or cut

taxes, to eliminate recessionary and inflationary gaps.

The answer depends more on one's views of

the appropriate size of the government, than pure economics.

10:26

At one end of the ideological spectrum,

liberals who think that there are many unmet

social and infrastructure needs usually

recommend increased government spending during recessions.

And tax increases to fight demand-pull inflation.

These actions either expand or preserve the absolute size of government.

10:48

On the other hand, there are conservatives,

who seek to shrink the size of government.

What fiscal policies do you think they will advocate,

to fight recessions or inflation?