Hi, welcome to Macroeconomics. This is Kate. This tutorial is on expansionary policy. As always, my key terms are in red, and my examples are in green.
In this tutorial we'll talk about what fiscal policy involves, and how the government can use these policies to expand or contract the economy. We're going to discuss the expansionary tools available when the economy is in a recession. You'll understand how these fiscal policy tools work, and can actually have a multiplied effect in the economy. And you'll recognize, finally, that the success of fiscal policy depends upon consumer confidence and understanding.
So there are two tools of fiscal policy, and they are government spending and taxation. So fiscal policy looks at the policies in these two different areas. The government can then use these two tools to stabilize our economy's movement through business cycles.
So expansionary policy, as your key term is defined, is either monetary or fiscal policy that is enacted to stimulate economic growth, as measured by the GDP growth rate. In this tutorial, we're focusing on fiscal policy.
So let's start with government spending. We know that our government certainly spends a lot of money. And they spend money in the economy in so many areas. This is just a few of them-- things like national defense, education and health care, welfare programs, infrastructure, you name it. If the government wants to then stimulate our economy and speed it up again, because maybe it's in a recession, one of the things they can do is spend more money in any of these areas in order to create jobs, or simply to put money in people's hands, give people money to spend.
So if we look at our expenditure approach to calculating GDP, Y is our economic activity. And economic activity in an economy is comprised of consumer purchases, investment in capital-- usually we think of it by businesses-- and government purchases. So the idea is that if the government starts by increasing spending, the hope is that this is also then going to encourage greater consumer spending, and greater business investment.
So generally the government intervenes when consumers are not spending, and neither are businesses, because the economy is slow. So if they start, then the hope is that we can pump money in and get consumers and businesses spending again.
The problem is, if they increase taxes in order to pay for that increased government spending, that's going to be counterproductive. Think about it-- if they create more programs, and try to give you more money to spend, but at the same time then increase your taxes, now they're taking that money away from you. So it's just completely counterproductive.
So unfortunately, without increasing taxes, what does our government have to do? Well, they have to borrow money. And the way our government borrows money is by selling treasury securities, to finance the increased government spending needed to stimulate the economy. And so they take on debt. Now keep in mind, when we repay the debt, tax revenue is then going to be needed to be used.
The second tool of the government is taxation. So we know that federal, state, and local governments all collect taxes from us, in order to fund programs. So another way to stimulate the economy would be to cut taxes, to give us more money to spend. So by either increasing government spending, or by cutting taxes, the government is really attempting to get us to spend money. They're trying to inject money into the economy. And so therefore expansionary fiscal policy is when government spending is greater than the tax revenue they're taking in. They're either increasing this, cutting tax revenue, or both.
So if the government increases spending, really what the hope is that it has a multiplied effect-- I've already kind of alluded to that-- by encouraging greater consumer and business spending. So the C and the I. So let's just say I get hired as a government employee, as a result of some kind of increased spending. Some funding in an area opens up some jobs, and I get one. I now have money that I didn't use to, to go out and spend in restaurants, and go on vacations, and things like that.
Now it doesn't just stop there. Those places of business are now doing better. They now have more money to do a lot of things, to pay their workers. And then those workers will, in turn, have more money to spend elsewhere.
So how much will the multiplied effect be? There's actually a way to go about calculating this. Really it depends on how much of that money I make. Now how much of it am I going to spend versus save? Because if I save it all, it really creates no multiplied effect in the economy. I just store it in the bank, or store it somewhere, and it's not creating other jobs and becoming part of other people's income, to then go spend.
So the more I spend, the greater the multiplied effect there's going to be in the economy. So here's how we find it. What we do is we calculate a consumption multiplier. And it's 1 divided by 1 minus the MPC. What is the MPC? Our MPC is our consumers' marginal propensity to consume. It's the percentage of all income that is being spent in the economy.
So say the government wants to increase GDP. Here's an example for you. Let's say they spend $10 billion on new programs, and we know that the marginal propensity to consume is 0.75, or 75%. What overall effect will this have on the economy? Will it stop at $10 billion? Will it just mean $10 billion increase in economic activity? Well, let's see.
The MPC of 0.75 tells us that economy-wide, people will spend 75% of additional income they receive. As an individual-- just as an example for you-- if I make an additional $100 this paycheck, let's say, my personal MPC of 0.75 tells me I'll spend $75 of it, and save $25. But we're looking at the overall economy. So that gives us a multiplier of four, because these 1 over 1 minus the 0.75, which gives us the 0.25.
So here's the idea. If the government injects $10 billion into the economy by increasing spending, this could in theory generate an additional $40 billion in economic activity, because we multiply it times our multiplier.
Now if the government does this through taxes-- so let's say they cut taxes by that $10 billion. Now we have to look at the impact this will have on consumption first, in order to find our multiplied effect. So it will increase our consumption by the MPC times the amount of the tax benefit. So if we take our MPC of 0.75, multiply times the extra $10 billion that people now have, we find that people will increase their consumption by $7.5 billion dollars. So we take that, multiply times our multiplier, and we see that this has the potential to increase economic activity by actually a multiplier of three-- if you think about it that way-- but by $30 billion, as a result of the $10 billion tax cut.
So one of the things we really need to keep in mind is why economics is called a social science. It's a social science because we rely on how people react and behave. So these policies certainly make sense. I know when I was first reading them and learning about them, oh yeah, that absolutely makes sense. But we have to understand how people are going to react and behave when these policies are then put in place.
So for example, a massive government spending campaign is all fine and well, but it will do absolutely nothing to get us out of a recession if consumer confidence is too low. Because what will they do with that money? They'll just end up saving it. So if people are really still afraid that nothing is turning around, and you get a little bit of extra money, you're not going to spend that's going on vacation or buy clothes. You're going to save it, in case you lose your job. So the result would then just be more government debt.
So when any policy is put in place, it generally takes some time, obviously, for it to improve the economy. It doesn't happen overnight. This amount of time is called a lag in economics, and unfortunately the longer it takes to see the improvement, the more people can actually lose confidence.
And the kicker of it is that confidence is exactly what we need to help the policy work, because as soon as consumers and businesses are confident, they start spending money. So that can be a problem. This is why it's really important for people to be educated in this field, and to understand. And it's also important that we have a media that's communicating these policies to us in a fair and accurate manner.
So in this tutorial we looked at how fiscal policy involves both government spending and taxation, and we focused on expansionary policy-- so during a recession, what the government can do. And we learned that the government can increase spending, and/or reduce taxes to give us more money to spend. Either way, expansionary policy can have a multiplied effect. And finally, we looked at how the success of fiscal policy really depends upon consumer confidence and understanding. Thanks so much for listening. Have a great day.