Download loanable funds market

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Tax Systems & Market
for Loanable Funds
Analyze the features of the US’s tax system to understand
how it works to stabilize the economy
Explain and understand the loanable funds
market/crowding out effect
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Discussion Question:

Analyze and evaluate the following statement:
“Using monetary or fiscal policy to pump up the economy is
counterproductive—you get a brief high, but then you have the
pain of inflation.”
1.
Explain in terms of AD-AS model.
2.
Valid argument against stabilization policy?
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Answer:
1.
An increase in AD, regardless of what type of expansionary
policy is enacted, in order to close a recessionary gap may
eliminate high levels of unemployment and increase GDP;
however, the increase in aggregate price level (inflation)
that occurs as a result is a negative side-effect.
2.
Not a valid argument. Whenever the SR equilibrium is not
at LR full-employment level of output as a result of some
type of decline in AD, any discretionary monetary or fiscal
policy put in place to close an inflationary gap will return
the economy back to prerecession level price level and
output.
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Progressive, Regressive, and
Proportional Tax Systems

Progressive: takes greater percentage of income from highincome groups than low-income groups

Regressive: takes a greater percentage of income from lowincome groups than high-income groups

Proportional: takes the same percentage of income from all
groups regardless of level of income

Vertical Equity: concept that people in different income groups
should pay different rates of taxes or different percentages of
their incomes as taxes. “Unequals should be taxed unequally”
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Progressive, Regressive, and
Proportional Tax Systems
TAX
COLLECTED
PG
PP
RG
INCOME
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Examine the Outcomes:
INCOME
TAX RATE
(PROG.)
TAX RATE
(REG.)
TAX RATE
(PROP.)
$10,000
10%
20%
20%
$50,000
20%
5%
20%
$100,000
30%
2%
20%
1. Total revenue generated in A.) Progressive? B.) Regressive? C.)
Proportional?
2. What is the “fairest” system?
3. Include the concept of MPC/MPS in your analysis. Why do we have the tax
system that we do?
***What type of tax is…FICA? Sales tax?
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Progressive Tax System Features

SELF STABILIZING!!!!

Tax rates vary with income level

In periods of SR expansion/contraction (recessionary or
inflationary gaps) GDP, thus income increases or decreases



Income increase (inflationary) tax rate increases, reducing
disposable income block, thus decreasing AD in the SR

Vice versa holds true as well
Automatically works to close positive and negative output gaps
According to the National Bureau of Economic Research this
feature of out tax system “offset perhaps as much as 8
percent of initial shocks to GDP.”
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Automatic Stabilizer:
Transfer Payments

Unemployment insurance benefits, food stamps, temporary
assistance for needy families, housing & energy assistance to
low income families, automatically increase during a
recession:
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
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
Supports consumption spending and aggregate demand,
which offset the decline in economic activity.
During economic prosperity, tax collections automatically rise
and transfer payments automatically decline
Automatic stabilizers are not strong enough to completely
eliminate recessionary or inflationary gaps
Measures occur free from government approval or
disapproval & they are constantly working to move
economy to LREQ
Remember: Fiscal Policy Components
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Crowding-Out Effect

Occurs when government wants to increase spending (G) and
needs to borrow money to do so…deficit spending

Money borrowing occurs in the loanable funds market

Main Idea: as G borrows more money, they are artificially
driving up interest rates



As interest rates increase, firms/households invest less in durable
goods
Ultimately, a bump in G will not have the assumed effect on output
that people assume because of the decrease in I that will occur in
theory
Highly debated theory with many speculated circumstances
and outcomes based on specific market factors
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Crowding-Out Effect

Loanable Funds Market creates a model for us to analyze how
changes in interest rates will affect the demand and supply of
money

Who demands money?




Households: houses, cars, education, ect.
Firms: investment in capital
Governments: any expenditure not covered by tax revenue
Foreign markets: their market’s interest rates higher that another
*Note: The loanable funds market has been on 3 of the last 5 AP
FRQ sections…
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Loanable Funds Market Illustrated
Interest
Rate
LFS
R

LFE
LFD
Q
Quantity of $

Need to know this model!

Governed by the same
principles as Micro S/D model

Supply of Loanable Funds (LFS)

Demand of Loanable Funds
(LFD)

Loanable Funds Equilibrium
(LFE)
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Crowding Out Effect Illustrated
Interest
Rate
LFS
 LFE
R
2
 LFE
LFD2
LFD
Q
Quantity of $

As G borrows more,
demand for money
increases (LFD )

LFD shifts right, quantity
of $ demanded
increases, and
INTEREST RATES
INCREASE
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Quick Quiz
1.
What are the 3 forms of expansionary fiscal policy?
2.
What are the 3 forms of contractionary fiscal policy?
3.
What is the goal of macroeconomic policy?
4.
Illustrate the crowding out effect in the loanable funds
market.