Fiscal policy to address output gaps | AP Macroeconomics | Khan Academy

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.

In other videos, we talk about how there could be a self-adjustment mechanism in the long run. Because we are below full employment, folks, especially those who want to get a job, might say, "Hey, I'm willing to work for less and less." Maybe our short-run aggregate supply curve shifts down over time, and we get to a state something like this.

In that case, this would be our short-run aggregate supply curve too. Suddenly, we would be at 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.

You are the government, and you want to do something about it. You want to get back to full employment output. Well, there are a couple of levers you have: fiscal policy. Fiscal policy 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.

The theory is if the government spends more, that would increase total output. The other theory is if the government taxes less, there's more money out of the economy, and that could also increase total output.

There’s also monetary policy, which we’re not going into detail on in this video, but monetary policy is messing with the money supply. If there's more money out there and lower interest rates, it might increase output, and then the opposite could be true the other way.

But we are going to focus on fiscal policy. As a government, what we want to see happen is this aggregate demand curve shift to the right. 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 reach our full employment output? Well, there are two levers we can think about, as we just said: government spending and taxation.

Now, a big misconception is that a lot of folks say, "Well, if I increase spending by a hundred billion dollars, that's the 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. These are all very simple models. Our regular multiplier is one over one minus the marginal propensity to consume. While our 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. The reason you have this marginal propensity to consume in the numerator is that if I had 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 going to spend all that hundred dollars.

I am going to spend some fraction of it, really the marginal propensity to consume times a hundred. While if the government just goes out there and spends a hundred dollars, well, that hundred dollars got spent.

To see the impact, the difference in impact, let's go through a little bit. Let’s do an example. Say a situation where the government just spends one hundred billion dollars. If the government wants to spend one hundred billion dollars, what is going to be the impact?

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? Well, in this situation, you’re going to have one hundred billion dollars of spending times the multiplier, which is one over one minus our marginal propensity to consume, 0.8.

So, this is going to be equal to one hundred billion dollars divided by 0.2. Well, 0.2 is one-fifth, so this is going to be the same thing as dividing by one-fifth or multiplying by five. You’re going to have an increase in output, based on this very simple model, of five hundred billion dollars.

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 one hundred billion dollars. So decrease taxes by one hundred billion dollars, and we're going to assume the exact same marginal propensity to consume.

Well, in that situation, what’s our tax multiplier? We’re decreasing taxes, so that'll offset this negative. The increase in the economy is going to be one hundred billion dollars times our marginal propensity to consume, 0.8, divided by one minus the marginal propensity to consume.

Well, this part was exactly the same as what we had over there, so that’s going to be equal to five hundred billion dollars this part times 0.8. What is that going to be? Well, that is going to be equal to four hundred billion dollars.

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 would then spend eighty billion of that, and the people who get that would spend sixty-four billion, and on and on and on.

So it eventually ends up being five hundred billion, but with the decrease in taxes of one 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 one hundred billion, I might save some of it based on this marginal propensity to consume.

I might save twenty billion of it and spend the other eighty billion, and so that’s why, based on this simplified model, you might have a lower total impact.

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.