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Chapter 28

Chapter 28. Managing Aggregate Demand: Fiscal Policy. Next, let us turn to the problems of our fiscal policy. Here the myths are legion and the truth hard to find. JOHN F. KENNEDY. Income Taxes & Consumption Schedule. Fiscal policy Government’s plan for spending & taxation

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Chapter 28

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  1. Chapter 28 Managing Aggregate Demand: Fiscal Policy Next, let us turn to the problems of our fiscal policy. Here the myths are legion and the truth hard to find. JOHN F. KENNEDY

  2. Income Taxes & Consumption Schedule • Fiscal policy • Government’s plan for spending & taxation • To steer aggregate demand • Desired direction • Disposable income (DI = Y-T) • Real GDP (Y) • Taxes (T)

  3. Income Taxes & Consumption Schedule • Tax increase • Consumption schedule – shift downward • Total spending schedule – shift downward • Equilibrium GDP (demand side) – reduced • Tax decrease • Consumption schedule – shift upward • Total spending schedule – shift upward • Equilibrium GDP (demand side) - increased

  4. Figure 1 How tax policy shifts the consumption schedule C Tax Increase Tax Cut Real Consumer Spending Real GDP

  5. The Multiplier Revisited • Change in government purchases • Every dollar - spent • Multiplier effect • Change in taxes • Not every dollar is spent • Multiplier – smaller

  6. The Multiplier Revisited • Multiplier • Reduced by income tax • Income tax • Reduces - fraction of each dollar of GDP • Consumers actually receive and spend • Oversimplified formula 1/(1-MPC) • Overstates multiplier • Ignores variable imports • Ignores price-level changes • Ignores income tax

  7. Figure 2 The multiplier in the presence of an income tax 45° E1 E0 C+I+G1+(X-IM) C+I+G0+(X-IM) $400 Real Expenditure 0 Real GDP 7,000 6,000

  8. The Multiplier Revisited • Taxes – change multiplier analysis • Tax changes - smaller multiplier effect • Than changes in spending • Income tax - reduces multipliers for • Tax changes • Changes in spending

  9. The Multiplier Revisited • Automatic stabilizer • Feature of economy • Reduces its sensitivity to shocks • Sharp increase/decrease in spending • Automatically – shock absorber • Lower multiplier • E.g. • Personal income tax • Unemployment insurance

  10. The Multiplier Revisited • Government transfer payments • Payments to individuals • Not compensation for production • Add to income • Function as negative taxes • T = taxes - transfers

  11. Planning Expansionary Fiscal Policy • Expansionary fiscal policy • Raise government purchases • Reduce taxes • Increase transfer payments • To close recessionary gap • Between actual and potential GDP

  12. Figure 3 Fiscal policy to eliminate a recessionary gap Potential GDP Potential GDP F E 45° 45° Recessionary gap Real Expenditure Real Expenditure C+I+G0+(X-IM) C+I+G0+(X-IM) C+I+G1+(X-IM) 6,000 0 0 7,000 7,000 6,000 (a) (b) Real GDP Real GDP

  13. Planning Contractionary Fiscal Policy • Contractionary fiscal policy • Reduce government purchases • Increase taxes • Reduce transfer payments • To close inflationary gap • Between actual and potential GDP • Can avoid inflation

  14. Choice: Spending Policy & Tax Policy • Higher spending & lower taxes • Same aggregate demand curve • Same increases in real GDP and prices • Active fiscal policy • Smaller public sector • Larger public sector

  15. Figure 4 Expansionary fiscal policy S D0 D1 E A Price Level Rise in real GDP Rise in Price level D0 D1 S Real GDP

  16. Choice: Spending Policy & Tax Policy • Advocates - bigger government • Expand demand • Higher government spending • Contract demand • Tax increase • Advocates - smaller government • Expand demand • Cut taxes • Reduce demand • Cut expenditures

  17. Some Harsh Realities • Complications • I, X-IM, C schedules • Shift with • Expectations, Technology • Events abroad, Other factors • Multipliers – not precisely known • Target - full-employment GDP • Dimly visible • Fiscal policies • Time lags

  18. Some Harsh Realities • Change unemployment rate • Long-run costs • Running large budget deficits • Inflationary cost • How large • Supply-side economics

  19. Idea Behind Supply-Side Tax Cuts • Certain types of tax cuts • Increase aggregate supply • Increase supply of labor & capital • Reduce inflation • Raise real GDP • Lower personal income tax rates • Reduce taxes on income from savings • Reduce taxes on capital gains • Reduce the corporate income tax

  20. Figure 5 The goal of supply-side tax cuts S0 S1 D A B Price Level D S0 S1 Real GDP

  21. Figure 6 A successful supply-side tax reduction S0 S1 D0 D1 E A C Price Level D0 D1 S0 S1 Real GDP

  22. Idea Behind Supply-Side Tax Cuts • Undesirable side effects • Small magnitude of supply-side effects • Demand-side effects • Problems with timing • Effects on income distribution • Losses of tax revenue

  23. Figure 7 A more pessimistic view of supply-side tax cuts S0 D0 D1 S1 E C Price Level D0 D1 S0 S1 Real GDP

  24. Idea Behind Supply-Side Tax Cuts • Supply-side tax cuts • Effectiveness • Depends on what kinds of taxes are cut • Stimulate business investment - greater impact • Increase aggregate supply - more slowly • Than - increase aggregate demand • Faster economic growth in long run

  25. Idea Behind Supply-Side Tax Cuts • Supply-side tax cuts • Demand-side effects • Overwhelm supply-side effects in short run • Likely to widen income inequalities • Lead to larger budget deficits

  26. Graphical treatment of taxes and fiscal policy • Variable taxes • Vary with GDP • Personal income tax • Corporate income tax • Sales tax • Fixed taxes • Don’t vary with GDP • Property taxes

  27. Figure 8 How variable taxes shift the consumption schedule C Variable Tax Cut Variable Tax Increase Real Consumer Spending Real GDP

  28. Graphical treatment of taxes and fiscal policy • Variable taxes • Flatten the consumption schedule • Government purchases (goods & services) • Add to total spending - directly • C + I + G + (X – IM)

  29. Graphical treatment of taxes and fiscal policy • Higher taxes • Reduce total spending – indirectly • Lower disposable income • Reduce: C component of C + I + G + (X – IM) • Government’s actions • Raise or lower equilibrium level of GDP • Depends on • Spending • Taxing

  30. Figure 9 Consumption schedule with fixed vs. variable taxes C1 C2 Real Consumer Spending Real GDP

  31. Table 1 Effects of an income tax on consumption schedule

  32. Table 2 The relationship between consumption and GDP

  33. Table 3 Total expenditure schedule with a 20% income tax

  34. Figure 10 Income determination with a variable income tax 45° 8,000 E 7,000 C+I+G+(X-IM) Real Expenditure 6,000 5,000 4,000 3,000 0 4,000 6,000 8,000 Real GDP

  35. Multipliers for tax policy • Tax multiplier for fixed taxes • Change in tax • Change in consumer spending • Vertical shift of consumption schedule

  36. Figure 11 The multiplier for a reduction in fixed taxes 45° C0+I+G+(X-IM) C1+I+G+(X-IM) Real Expenditure $300 billion 6,000 6,750 Real GDP

  37. Algebraic treatment of fiscal policy • Y=C+I+G+(X-IM) • C=a+bDI • DI=Y-T • T=T0+tY • C=a-bT0+b(1-t)Y

  38. Algebraic treatment of fiscal policy

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