Closing An Inflationary Gap and Tax Cuts Versus Government Spending

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Do curso por University of California, Irvine

Strategic Business Management - Macroeconomics

28 classificações

University of California, Irvine

Strategic Business Management - Macroeconomics

28 classificações

This course weds business strategy with the principles of macroeconomics. It offers valuable a powerful toolbox together with cases and lessons across all major functions of business, management, from finance, operations management, and marketing to human resource management, organizational behavior, statistics, and, of course, business strategy.

Na lição

The Keynesian Model and Fiscal Policy

Fiscal Policy and the Business Climate6:15

The Coming of John Maynard Keynes7:48

The Analysis of the Keynesian Model, Part One12:14

Analysis of the Keynesian Model, Part Two13:06

The Keynesian Expenditure Multiplier8:43

Closing Recessionary and Inflationary Gaps5:28

Closing An Inflationary Gap and Tax Cuts Versus Government Spending7:32

The Keynesian Model Then and Now7:45

Conheça os instrutores

Dr. Peter Navarro
Professor
Paul Merage School of Business

[MUSIC]

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

So in this module, we are going to also learn how to close an inflationary gap.

Such a gap can occur when economy grows too fast through the resource it has and

begins to suffer from demand-pull inflation.

And in this module, we are also going to briefly address the age old fiscal

policy question as to whether it's better to use tax cuts or

increase government expenditures to fight recessions.

[MUSIC]

Suppose then that this time around India is facing an inflationary gap

as illustrated in this figure.

You can see here that the economy is in equilibrium at point A where aggregate

expenditures crosses the 45 degree line of aggregate production and

income is at 960 billion rupees.

But this is 60 billion rupees above the full employment

output of 900 billion rupees.

In such a case, we know that there will be strong upward pressure on prices,

even though such pressures are not visible in the Keynesian model.

Remember, in the Keynesian model, we assume that prices are fixed.

Now in light of these inflationary pressures,

how might fiscal policy be used to close the inflationary gap?

[MUSIC]

Of course, to close the inflationary gap depicted in the figure,

we must use contractionary fiscal policy.

The goal is to rein in aggregate demand and thereby rein in demand-pull inflation.

Now as we already know, contractionary fiscal policy means either

cutting government expenditures or raising taxes, or

adopting some combination of the two to cool inflationary pressures.

So take a minute now to calculate how much the Indian government should either

decrease government expenditures or

increase taxes to close the 60 billion rupee gap.

And as a hint to solving this problem, take a look at the slope of the aggregate

demand curve to first calculate the Keynesian multiplier.

[MUSIC]

From the figure,

you can see that the slope of the aggregate expenditures curve is 0.75.

That in turn means the Keynesian multiplier is four.

Therefore, the Indian government must cut government spending by

15 billion rupees to close the 60 billion rupee inflationary gap.

Alternatively, with the Keynesian tax multiplier of 3,

it can raise taxes by 20 billion rupees to achieve the same result.

Did you get those answers right?

If so, please move on.

But if not, please go back and review the material before moving on.

[MUSIC]

Now you might be wondering at this point whether it's more preferable to

raise taxes or cut government spending to close an inflationary gap.

Or whether it's more preferable to increase government spending or

cut taxes to close a recessionary gap.

These are very good questions to ask.

And the answers have tremendous implications for the business environment.

This is because the choices governments make over fiscal policy not only

affect the tax burden of companies.

The choices will also significantly affect the economy

that businesses are operating in.

So how do you answer these questions?

In fact, there are at least two dimensions to consider.

[MUSIC]

As a rule, there is a greater short-term risk in relying on tax cuts,

rather than increase government spending to fight recessions.

This is because citizens may save more of the tax cuts they receive than

the government thinks they are going to spend.

In the event of such an unexpected savings leakage,

any tax cut would therefore be less effective than planned.

And at least on these grounds, a fiscal stimulus in the form of increased

government spending would appear to offer a more certain outcome.

That said, there are however, the longer term consequences to consider.

And these long-term consequences are best captured in a short

run discussion of the ideological dimensions of fiscal policy.

[MUSIC]

As a key definition, a person's political ideology reflects that

person's set of ideals, principles and doctrines they may embrace.

For example, in the economic arena,

ideological liberals will tend to prefer increased government spending

over tax cuts in the application of fiscal policy to fight recessions.

The underlying motivation is to expand the role of government to meet what liberals

see as social welfare goals and

infrastructure needs that might not otherwise be met.

By the same token, liberals will favor tax

hikes rather than reduced government spending to close inflationary gaps.

Because this strategy preserves the role and size of government and

may provide the additional revenues the government needs to grow.

At the other end of the spectrum, there are, however,

ideological conservatives who prefer to shrink the size of government.

So what fiscal policies do you think ideological conservatives will

favor to fight recessions or inflation?

Take a minute to jot down your answer now before moving on.

[MUSIC]

So what fiscal policies do you think ideological conservatives will

favor to fight recessions or inflation?

Of course, conservatives will generally favor tax cuts during recessions and

cuts government spending during overheated expansions

to fight demand-pull inflations.

Both strategies dovetailed with the conservative desire to limit

the role of government.

Now to end this module,

why don't you spend a few minutes thinking about your own political ideology?

Are you a conservative or a liberal, or perhaps a libertarian, or a socialist?

Write down some ideas about this, and see if you can figure out just why and

how your own political ideology has been shaped as it has been.

And of course, there are no right answers in this particular question,

only an opportunity here to think a bit more broadly about who you are and

what you believe in.

[MUSIC]

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