[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]
