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How does the government use spending and taxes to close output gaps?

Topic 3.8 Fiscal Policy: explain how expansionary and contractionary fiscal policy use government spending and taxes, with the multiplier, to close recessionary and inflationary output gaps.

A focused answer to AP Macroeconomics Topic 3.8, covering discretionary fiscal policy, expansionary and contractionary tools, using the spending and tax multipliers to size the policy needed to close an output gap, and the lags of fiscal policy, with full worked calculations.

Generated by Claude Opus 4.812 min answer

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  1. What this topic is asking
  2. Expansionary and contractionary policy
  3. Sizing the policy with the multiplier
  4. The limits of fiscal policy
  5. Try this

What this topic is asking

Topic 3.8 is fiscal policy: the government's deliberate use of spending and taxes to influence aggregate demand. The College Board wants you to choose expansionary or contractionary policy for a given gap, show it on the AD-AS graph, and use the multipliers to size the policy. This is one of the most heavily tested free-response topics in Macro.

Expansionary and contractionary policy

Match the tool to the gap: a recessionary gap (output below potential, high unemployment) needs expansion; an inflationary gap (output above potential, overheating) needs contraction.

Sizing the policy with the multiplier

Because of the multiplier, the government does not need to change spending by the full size of the gap. To close an output gap exactly:

ΔG needed=output gapspending multiplier=gap×(1−MPC)\Delta G \text{ needed} = \frac{\text{output gap}}{\text{spending multiplier}} = \text{gap} \times (1 - MPC)

ΔT needed=output gap∣tax multiplier∣\Delta T \text{ needed} = \frac{\text{output gap}}{|\text{tax multiplier}|}

Because the tax multiplier is smaller in absolute value, a tax change must be larger than a spending change to produce the same effect on GDP.

The limits of fiscal policy

Fiscal policy is powerful in theory but constrained in practice:

  • Lags. A recognition lag (spotting the problem), a decision lag (legislating), and an implementation lag (spending taking effect) mean policy can arrive late, even after the gap has changed.
  • Crowding out. Government borrowing to fund a deficit can raise interest rates and reduce private investment, partly offsetting the policy (the Unit 5 topic).
  • Political constraints. Spending and tax changes are politically contested and hard to reverse.

Try this

Q1. Which fiscal policy closes an inflationary gap? [1 point]

  • Cue. Contractionary fiscal policy (cut spending or raise taxes), shifting AD left.

Q2. A recessionary gap is 600 and the spending multiplier is 4. How much extra government spending closes it? [2 points]

  • Cue. 6004=150\frac{600}{4} = 150.

Exam-style practice questions

Practice questions written in the style of College Board exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.

AP 2018 (style)1 marksMultiple choice. An economy has a recessionary gap of 200 and a marginal propensity to consume of 0.75. To close the gap exactly, the government could increase its spending by (A) 50. (B) 150. (C) 200. (D) 800. (E) 1,000.
Show worked answer →

The answer is (A). The spending multiplier is 11−0.75=4\frac{1}{1 - 0.75} = 4. To raise GDP by 200, the required increase in government spending is gapmultiplier=2004=50\frac{\text{gap}}{\text{multiplier}} = \frac{200}{4} = 50.

(C) ignores the multiplier. (D) and (E) multiply rather than divide by the multiplier. (B) is unrelated. Only 50, when multiplied by 4, raises GDP by 200, so (A) is correct.

AP 2021 (style)6 marksFree response. An economy is in a recessionary gap. The marginal propensity to consume is 0.8. (a) Draw a correctly labelled AD-AS graph showing the recessionary gap with AD, SRAS, and LRAS. (b) Identify whether expansionary or contractionary fiscal policy is appropriate. (c) On your graph, show the intended effect of the policy. (d) The gap is 500. Calculate the increase in government spending needed to close it. (e) Calculate, instead, the size of the tax cut needed to close it. (f) Explain one reason the actual effect of fiscal policy may differ from the calculation.
Show worked answer →

A 6-point graphing-and-calculation FRQ.

(a) Graph (1 point): vertical LRAS at YfY_f; AD crossing SRAS at Y1<YfY_1 < Y_f, price level PL1PL_1.

(b) Policy (1 point): expansionary fiscal policy.

(c) Shift (1 point): show AD shifting right toward the LRAS, restoring output to YfY_f.

(d) Spending (1 point): spending multiplier =11−0.8=5= \frac{1}{1 - 0.8} = 5; required spending =5005=100= \frac{500}{5} = 100.

(e) Tax cut (1 point): tax multiplier =−0.80.2=−4= \frac{-0.8}{0.2} = -4; required tax cut =5004=125= \frac{500}{4} = 125 (a cut of 125).

(f) Reason (1 point): any one of crowding out, recognition or implementation lags, or the gap being mis-measured.

Markers reward the rightward AD shift to YfY_f, the spending figure 100, and the tax-cut figure 125.

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