Inflationary & Recessionary Gaps: Fiscal Policy & Multiplier Effects in Economics

Inflationary Gap

Current Output > Potential Output

Recessionary Gap

Current Output < Potential Output

Long Run Equilibrium

Current Output = Potential Output

Natural Rate of Unemployment

AKA Full Employment AKA No Cyclical Unemployment

Potential Problem

Inflation

Monetary Policy

Adjustment of the money supply and interest rates

Fiscal Policy

Adjustment of taxes, government spending on goods and services, and government spending on transfers.

Expansionary Fiscal Policy

A policy aimed at increasing economic activity.

Contractionary Fiscal Policy

A policy aimed at decreasing economic activity.

Demand Shock

A sudden event that increases or decreases demand for goods and services.

Supply Shock

A sudden event that increases or decreases supply of goods and services.

Stagflation

An economic condition characterized by slow growth and high inflation.

Multiplier Effect

When C or I or G or X increases by $1, this multiplies into more spending in the economy.

GDP Formula

GDP = C + I + G + Xn

Multiplier Formula

Multiplier = 1 / (1 - MPC)

MPC

Marginal Propensity to Consume

MPS

Marginal Propensity to Save

Total Spending

Original Spending X The Multiplier = Total Spending (change in GDP)

Government Spending Increase Example

With an MPC of .9, a $50 billion dollar increase in spending will lead to a $500 billion increase in GDP.

Recognition Lag

The time it takes to recognize an economic issue.

Decision Lag

The time it takes to decide on a course of action.

Implementation Lag

The time it takes to implement a decision.

Multiplier

A factor that quantifies the change in total spending (GDP) resulting from an initial change in spending.

Spending Multiplier

Calculated as 1/(1-MPC) or 1/MPS, representing the effect of government spending on GDP.

Tax Multiplier

Calculated as MPC/MPS, representing the effect of changes in taxes on GDP.

Total Decrease in Spending

Calculated as Original Spending X Multiplier.

Negative shift in Aggregate Demand

A decrease in total demand in the economy, quantified in this case as $800 billion.

$200 billion spending decrease

Will create a negative shift in Aggregate Demand equal to $800 billion.

Government spending increase

To address a recessionary gap, the government should increase spending.

$80 billion spending increase

The amount by which government spending should change to close a $400 billion recessionary gap.

Multiplier effect on Taxes

The effect of tax changes on GDP is indirect and smaller than that of government spending.

Lump-sum tax decrease

An example where the government lowers taxes by a fixed amount, such as $1000.

MPC = .9

Indicates that 90% of additional income will be spent.

$900 of new spending

Will multiply by a factor of 10 leading to $9000 of additional real GDP.

Transfer payments

Payments made by the government to individuals, such as welfare or unemployment benefits.

$500 increase in transfer payments

Will lead to $2000 of additional GDP when considering an MPC of .8.

Conclusion on spending vs taxes

A spending increase by the government has a larger effect on GDP than an equally sized decrease in taxes.

Tax/Transfer Multiplier

Always smaller than the spending multiplier and is 1 less than the spending multiplier.

Spending Multiplier formula

Spending Multiplier = 1/(1-MPC) or 1/MPS.

Tax or Transfer Multiplier formula

Tax or Transfer Multiplier = MPC/MPS.

$2000 decrease in taxes

Leads to an increase in GDP because consumers have more disposable income.

$2000 increase in government spending

Also leads to an increase in GDP, calculated using the spending multiplier.

Total increase in GDP from spending

$2000 X 4 = $8000 total increase in GDP.

Total increase in GDP from tax decrease

$2000 X 3 = $6000 total increase in GDP.