AP Economics - Closing a Recessionary Gap with Tax Cuts

Introduction

• Objective: Close a $40 billion recessionary gap using tax cuts.
• Key Concept: Tax cuts have a less direct impact on the economy than government spending because a portion of tax cuts is saved rather than spent.

Key Concepts

Marginal Propensity to Consume (MPC)

• Definition: The fraction of additional income that a household consumes rather than saves.
• Example MPC: 0.5 means individuals spend half of any additional income, including from tax cuts, and save the rest.

Multiplier Effect

• Formula: Multiplier = 1 / (1 - MPC)
• Role in Closing Gap: Indicates how much total spending is generated by an initial change in spending.

Tax Cut Calculation - Example 1

Given:

• MPC = 0.5
• Recessionary Gap = $40 billion

Steps:

1. Calculate Multiplier:
   • Multiplier = 1 / (1 - 0.5) = 2
2. Initial Thought:
   • Cut taxes by $20 billion.
   • Consumers spend $10 billion (0.5 * $20 billion), failing to close the gap.
3. Correct Action:
   • Cut taxes by $40 billion.
   • Consumers spend $20 billion (0.5 * $40 billion).
   • Multiplied by 2, this spending closes the $40 billion gap.

Tax Cut Calculation - Example 2

Given:

• MPC = 0.8
• Recessionary Gap = $40 billion

Steps:

1. Calculate Multiplier:
   • Multiplier = 1 / (1 - 0.8) = 5
2. Correct Action:
   • Cut taxes by $10 billion.
   • Consumers spend $8 billion (0.8 * $10 billion).
   • Multiplied by 5, this spending closes the $40 billion gap.*

Conclusion

• Key Takeaway: Understanding the multiplier effect and the role of MPC is essential in determining the correct amount of tax cuts to effectively close a recessionary gap.
• Practice: Students are encouraged to practice these calculations with different values to enhance understanding.

Note: Ensure you are comfortable with calculating multipliers and understanding the effects of MPC on spending to effectively apply these concepts in different economic scenarios.