Description                                  
In this presentation, the narrator describes government fiscal policy in terms of closing recessionary and expansionary gaps in order to achieve economic equilibrium. The narrator also examines how government spending effects the economy. 

Fiscal Policy
Government Purchases 
  
Audio Transcript 

Marge: 
It's a good thing that the federal government started that big highway project just across town. That should pump a lot of money into the local economy. 

Narrator: 
Marge is right. A big government project like highway construction does pump a lot of money into the economy. In fact, government spending on goods and services can have a profound effect on aggregate output. 

Narrator: 
Consider the Keynesian Cross... when aggregate income is equal to aggregate expenditure, the economy is in a state of equilibrium. If this point of equilibrium corresponds to the full employment level, the government is likely to maintain the status quo with respect to spending. 

Narrator: 
Consider the case when full employment GDP is greater than equilibrium GDP... this creates a recessionary gap because the economy at equilibrium is operating below full employment

Narrator: 
The government may attempt to close this gap by increasing government spending. This shifts the aggregate expenditure curve upwards and establishes a new equilibrium closer to the full employment level of income. 

Narrator: 
Full employment can also occur below the expenditure income equilibrium. This produces an expansionary gap because the equilibrium GDP is greater than full employment GDP which creates inflationary pressure. 

Narrator: 
The government closes this gap by decreasing government spending. This shifts the aggregate expenditure curve downwards establishing a new equilibrium closer to the natural employment level. 

Narrator: 
A decrease in government purchases results in a relatively larger decrease in aggregate income. The same is true with an increase in government purchases. The result is a relatively larger increase in aggregate income. This is because changes in government purchases have a multiplier effect on aggregate income. 

Narrator: 
The government spending multiplier is defined as the ratio of the change in aggregate income to the change in government purchases. This is how the multiplier functions... when the government makes a purchase aggregate output increases and aggregate income immediately increases by the same amount. 

Narrator:  
As more people are hired and households receive more income, they spend more and save more. The additional amount spent is determined by the marginal propensity to consume. This results in a higher equilibrium income level. The increased consumption spending leads to yet another increase in output and aggregate income. The entire process continues with increases in spending becoming smaller and smaller until the effects are negligible. 

Narrator: 
From the graph, it is evident that a 1/2 trillion-dollar increase in government spending produces about $2 trillion-dollars in additional aggregate income. Thus, the multiplier is four.  

Narrator: 
The size of the multiplier is clearly related to the slope of the aggregate expenditure function... in other words, to the marginal propensity to consume. As households receive income, they spend the percentage determined by the marginal propensity to consume. In a repetitive manner, this increase in spending causes an increase in income, which in turn results in more spending until the effects of the multiplier are exhausted. 

Narrator: 
Given the marginal propensity to consume, one can also calculate the marginal propensity to save. The multiplier can then be derived by dividing one by the marginal propensity to save. By knowing the value of the multiplier, it's easy to calculate the change in aggregate income resulting from a change in government spending. The size of the multiplier is determined by the marginal propensity to consume. The larger the MPC, the larger the multiplier and the more dramatic the effect that a change in government spending has upon the economy as a whole. 

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