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Chapter 11

Chapter 11. 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. Roadmap. Chapter 8-10 establish the theoretical framework of the macro economy: AS-AD equilibrium

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Chapter 11

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  1. Chapter 11 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. Roadmap Chapter 8-10 establish the theoretical framework of the macro economy: AS-AD equilibrium Chapter 11-16 turn to the government policy Fiscal policy (Chapter 11) Monetary policy (Chapter 12, 13) Debate and trade-off (Chapter 14-16)

  3. Question for This Chapter How do taxes (T) affect equilibrium GDP (Y)?

  4. Tools of Fiscal Policy Government spending (G) Income Tax (T) Government Transfer (GT)

  5. Income Taxes & Consumption Schedule • Tax affects disposable income (DI = Y-T) • Real GDP (Y) • Taxes (T)

  6. 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

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

  8. The Multiplier Revisited • Change in government purchases G • Every dollar - spent • Multiplier effect ( ∆G/∆Y=1/(1-MPC) ) • Change in taxes T • Not every dollar is spent • Multiplier – smaller

  9. The Tax Multiplier: Fixed Tax Increase in G by 1 million ∆Y= 1 + 0.75 + 0.75^2 +0.75^3 + …… = 4 Decrease in T by 1 million ∆Y= 0.75 + 0.75^2 +0.75^3 + …… = 0.75(1+0.75+0.75^2+0.75^3+……) = 0.75*4 = 3

  10. The Tax Multiplier: Variable Tax Proportional income tax t=20% Increase in G by 1 million ∆Y = 1 + 0.75*(80%) + (0.75*80%)^2 + (0.75*80%)^3 + …… = 1 + 0.6 +0.6^2 +0.6^3 + ….. = 1/(1-0.6) = 2.5 ∆Y = 1/(1-(1-t)MPC)

  11. 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 (Chp. 9) • Ignores price-level changes (Chp. 10) • Ignores income tax

  12. 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

  13. The Multiplier Revisited • Taxes – change multiplier analysis • Fixed tax changes (T) - smaller multiplier effect • Than changes in spending • Variable income tax (t) - reduces multipliers for • Tax changes • Changes in spending

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

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

  16. Planning Expansionary Fiscal Policy • Expansionary fiscal policy • Raise government purchases (G↑) • Reduce taxes (T↓) • Increase transfer payments (GT↑) • T↓ + GT↑ → Net T↓ → DI=Y - Net T increase → C ↑ • AD = C + I +G + (X-IM) ↑ • To close recessionary gap • Between actual and potential GDP

  17. 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

  18. 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

  19. Planning Contractionary Fiscal Policy • Contractionary fiscal policy • Reduce government purchases (G↓) • Increase taxes (T↑) • Reduce transfer payments (GT↓) • AD = C + I + G + (X-IM) ↓ • To close inflationary gap • Between actual and potential GDP • Can avoid inflation

  20. Choice: Spending Policy & Tax Policy • Policy Alternative: G or T • Case 1: Fixed Taxes (MPC=0.75) • T 400 Y 1200 • G 400 Y 1600 • Case 2: Variable Taxes (t=20%) • T 400 Y 750 • G 400 Y 1000 • G↑ directly increases AD; T↓ indirectly increase AD through consumption

  21. Choice: Spending Policy & Tax Policy Higher spending, or lower taxes, or a combination of these two tools theoretically will achieve Same increase in AD curve Same increases in real GDP and prices

  22. Choice: Spending Policy & Tax Policy • In practice, the choice depends on how large a public sector policy-makers want to create • Conservatives  small government  advocate T (recession) or G (boom) • Liberals  large government  advocate G (recession) or T (boom)

  23. Some Harsh Realities • Theory shows gov can drive GDP to any level they want by using fiscal policy • Reality is more complicated • I, X-IM, C schedules • Shift with • Expectations (often driven by policy itself), Technology, Events abroad, Other factors • Multipliers – not precisely known • Target - full-employment GDP dimly visible • Fiscal policies have time lags

  24. Some Harsh Realities • Legislation level, lower unemployment rate through G↑ and T↓ • Long-run costs (Chp. 15) • Running large budget deficits • Inflationary cost • How large can we bear • Seems for expansionary fiscal policy, we always face a dilemma b/w low unemployment and high inflation • Any way out?

  25. Idea Behind Supply-Side Tax Cuts • Supply-side economics believes certain types of tax cuts • Increase aggregate supply • Increase supply of labor & capital • Reduce inflation • Raise real GDP

  26. Idea Behind Supply-Side Tax Cuts Examples of supply-side tax cuts  personal income tax rate stimulate incentive of working, labor supply ↑  tax on income from saving more saving  more investment  tax on capital gain stimulate investment and capital formation  corporate income tax With more labor and capital supply, AS curve ↑

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

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

  29. Idea Behind Supply-Side Tax Cuts • Undesirable side effects • Small magnitude of supply-side effects • Stronger demand-side effects • Tax cut may possibly induce individuals work more. But they will certainly spend more • Problems with timing • Primary short-run effect on AD, effects on AS come later • Effects on income distribution • Increase income equality • Losses of tax revenue, bigger deficit

  30. 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

  31. Summary Tools of fiscal policy: G, T and Transfer Multiplier for change in T is smaller than that for change in G A proportional income tax t reduces multiplier Government transfer acts as a negative tax Recessionary gap can be cured by G↑ or T↓ Inflationary gap can be cured by G↓ or T↑ Expansionary fiscal policy (G↑ or T↓) can raise inflation and create budget deficit Supply-side tax cuts push AS and hence avoid the undesirable results of expansionary policy

  32. 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

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

  34. 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)

  35. 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

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

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

  38. Table 2 The relationship between consumption and GDP

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

  40. 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

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

  42. 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

  43. 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

  44. Algebraic treatment of fiscal policy

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