[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. 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. Now assuming a marginal propensity to consume of 0.75, we see a reduction in consumption of $75 billion in step four. This triggers a cutback in sales and further cutbacks in employment, and the process continues. The ultimate impact of this demand shock on total spending can be determined by computing the change in income and consumption at each cycle of the circular flow. 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. 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. 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? 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. 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. Assuming the marginal propensity to consume is 0.8, how much will we have to increase government expenditures to close this gap? 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. From this insight we can calculate the Keynesian tax multiplier as simply the expenditure multiplier times the MPC. As illustrated in this figure. Note that only part of a tax cut is used to increase consumption. 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? The answer is $25 billion or $5 billion more than we needed to increase government expenditures to achieve the same result. 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. 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. Such a situation, is illustrated in this figure. The economy is in equilibrium at point a where aggregate expenditures crossed the 45 degree line of aggregate production and income is at $960 billion. But this is $60 billion above the full employment output of $900 billion. In such a case, we know that there will be strong upward pressures on prices. Even though such pressures, are not visible in the Keynesian model. 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. 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. 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. 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. 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. 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? That's right, conservatives will generally favor tax cuts during recessions and cuts in government spending to fight demand pull inflation.