[MUSIC] Okay, in our previous model of this lesson we have done the hard work of laying down a strong foundation for the application of fiscal policy. We have done so principally by developing the basic Keynesian model and introducing the concept of the Keynesian expenditures multiplier. Now it's time to put that Keynesian multiplier to work demonstrating the actual application of fiscal policy. So let's start with this example. [MUSIC] Suppose the potential GDP of India is 900 billion rupees, and actual GDP is at 800 rupees, and further assume a marginal propensity to consume of 0.8. Take a minute now to see if you can draw this situation using the Keynesian model. Then calculate the increase in government expenditures needed to close the recessionary gap of 100 billion rupees, and illustrate this in the model. So give it a try, and when you're ready, let's see if your figure and your answer is correct. [MUSIC] This figure shows what this recessionary gap looks like. Of course, to determine the degree of fiscal stimulus in this example we first have to calculate the Keynesian multiplier. Since the MPC it's 0.8, the MPS is 0.2, and 1/0.2 gives us a pretty big multiplier of 5. That means the Indian government only has to increase government expenditures by 20 billion rupees to close the 100 billion rupee recessionary gap. Did you get that right? If not, be sure to back up and figure out where you went wrong because this is really critical stuff. [MUSIC] Now, suppose the Indian government has a new ideologically conservative prime minister that is not particularly fond of the increase in the size of government to stimulate the economy back to full employment. Despite the urging of the more liberal opposition party. Instead, India's leader prefer to use tax cuts as the best stimulers. How much do you think taxes must be cut to close that same 100 billion rupee recessionary gap? Take a few minutes now to really think this through, and again, assume an MPC of 0.8. And here's a hint. You have to alter your calculation of the Keynesian multiplier a bit to account for the fact that people will save, rather than consume, at least some of any tax cuts they receive. So work this out and try to come up with the Keynesian tax multiplier. It's a neat puzzle here. [MUSIC] Okay, so how much does the Indian government have to cut taxes to close a 100 billion rupee recessionary gap? Again, assuming a marginal propensity to consume of 0.8. To solve this problem we first have to grasp this key point. A dollar's worth of tax cuts has slightly less of an expansionary effect than a dollar's increase in government expenditures. This is because consumers will not increase their expenditures by the full amount of the tax cut. Instead, they will save some portion of that tax cut based on their marginal propensity to save. From this insight, we can calculate the Keynesian tax multiplier as simply the expenditure multiplier times the MPC, as illustrated in this figure. Note that only part of the tax cut is used to increase consumption, while part of the tax cut is saved, rather than spent. That's a classic leakage from the circular flow. So how do incorporate that saving's leakage into the Keynesian tax multiplier? Well, since we already we know the Keynesian tax multiplier formula, solving our problem is easy. As shown in this figure. You can see that the Indian government must cut taxes by 25 billion rupees. Or, 5 billion rupees more than was needed to increase government expenditures, to achieve the same expansionary result. You arrive at this total by first multiplying the expenditure multiplier of 5 times the MPC, yielding a tax multiplier of 4. Then, 4 times the 25 billion rupee tax cut does yield the desired 100 billion rupee expansion. Did you get it right? If so, take a breather before moving on to the next module. If not, you may want to review the material in this module to see where you went wrong. [MUSIC]