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[MUSIC]

Â Let's pause briefly and assess where we are.

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

Â and its slope is flatter than the aggregate production curve.

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

Â are horizontal lines the investment and the government expenditure functions.

Â If we vertically sum these curves we arrive

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

Â Because the investment in government expenditure

Â functions are both horizontal lines the slope

Â of the aggregate expenditures function would be

Â the same slope as the consumption function.

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

Â this complete aggregate expenditures curve is illustrated in this figure,

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

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

Â aggregate expenditures curve AE crosses the 45

Â degree line of the aggregate production curve AP.

Â Now in the Keynesian model expansionary

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

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

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

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

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

Â in total output.

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

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

Â 1:57

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

Â Here we see that in step one, there is an

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

Â goods from a reduction in aggregate demand.

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

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

Â 2:54

In the Keynesian model it can be

Â easily shown mathematically that the multiplier is simple

Â the reciprocal of the marginal propensity to save.

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

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

Â 3:17

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

Â 0.5, 0.75, 0.8

Â and 0.9. This exhibit provides the multiplier

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

Â illustrating the first five steps of the multiplier.

Â 3:49

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

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

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

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

Â 4:10

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

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

Â The new equilibrium level of GDP is thus read off the

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

Â 4:34

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

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

Â From this example you can see now why the analogy of

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

Â Such expenditures trigger increased investment and consumption, and

Â the total expansionary effect is far larger than

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

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

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

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

Â 5:32

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

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

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

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

Â Now alternatively, we can

Â use a tax cut, instead of increased government

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

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

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

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

Â This is because a

Â dollar's worth of tax cuts has slightly less of

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

Â The reason is that consumers will not increase their

Â expenditures by the full amount of the tax cut.

Â Instead they will save a portion of that

Â tax cut based on their marginal propensity to save.

Â 7:07

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

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

Â retain the assumption that the marginal propensity to

Â consume is 8 and the multiplier is 5?

Â 7:37

We arrive at this total by first multiplying the expenditure

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

Â four. Then, four times the $25 billion tax

Â cut yields the desired $100 billion expansion.

Â 7:58

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

Â Suppose we face an inflationary gap instead.

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

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

Â 8:54

Now in light of these inflationary pressures, how might

Â fiscal policy be used, to close the inflationary gap?

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

Â 9:11

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

Â Where, contractionary fiscal policy involves reduced government expenditures

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

Â 9:29

More specifically, from the figure, we see that

Â the slope of the aggregate expenditures curve is

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

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

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

Â At a multiplier of four either fiscal policy

Â tool will lead to the desired economic contraction

Â of $60 billion.

Â 10:06

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

Â to increase government spending, or cut

Â taxes, to eliminate recessionary and inflationary gaps.

Â The answer depends more on one's views of

Â the appropriate size of the government, than pure economics.

Â 10:26

At one end of the ideological spectrum,

Â liberals who think that there are many unmet

Â social and infrastructure needs usually

Â recommend increased government spending during recessions.

Â And tax increases to fight demand-pull inflation.

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

Â 10:48

On the other hand, there are conservatives,

Â who seek to shrink the size of government.

Â What fiscal policies do you think they will advocate,

Â to fight recessions or inflation?

Â