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Debate: Should the Government Intervene? • The debate is partly political. • It also depends on strictly economic questions: – How long are the lags? – How effective are the automatic stabilizers? Debate: Should the Government Intervene? – Long lags attempts at stabilizing the economy can actually destabilize it • How fast the economy’s self-correcting mechanism works • How long the lags in stabilization policy are • How accurate economic forecasts are FIGURE 27-7 Expansionary Fiscal Policy S D1 Price Level D0 A Rise in price level E D1 S Rise in real GDP D0 Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Idea Behind Supply-Side Tax Cuts • Supply-side economics = idea that taxes AS – GDP – price level FIGURE 27-8 The Goal of SupplySide Tax Cuts S0 S1 Price Level D A B S0 S1 D Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved. 27-9 A Successful SupplySide Tax Reduction FIGURE D1 S0 S1 Price Level D0 A C E D1 S0 S1 D0 Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Idea Behind Supply-Side Tax Cuts • The tax cuts particularly favored are: – Lower personal income tax rates – Lower or even zero taxes on income from saving – Lower taxes on capital gains – Lower corporate income taxes The Idea Behind Supply-Side Tax Cuts • Some Flies in the Ointment – The small magnitude of the likely effects – The large effects on aggregate demand – The problems in timing • The supply effects will take a long time to occur • The demand effects will take only a short time – The effects on income distribution – The loss of tax revenue 27-10 A More Pessimistic View of Supply-Side Tax Cuts FIGURE D1 S0 S1 Price Level D0 C E D1 S0 S1 D0 Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Toward Assessment of SupplySide Economics • Supply-side tax cuts have their pros and cons. • It is unlikely, however, that they can work as strongly or as quickly as their most ardent admirers think. 30-5 Stabilization Policy with a Flat AS Curve FIGURE D1 D0 D2 A 101 Rise in price 100 99 Price Level Price Level D0 S E 101 E 100 Fall in price 99 S S B S D0 Rise in output 6,000 6,400 D1 D2 D0 Fall in output 5,600 6,000 Real GDP Real GDP (a) Expansionary Policy (b) Contractionary Policy Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. 30-6 Stabilization Policy with a Steep AS Curve FIGURE D1 S S D0 D0 A 110 Rise in price E D1 100 90 D0 S Rise in output 6,000 6,100 Real GDP (a) Expansionary Policy Price Level Price Level 110 D2 E 100 Fall in price B 90 D0 S Fall in output D2 5,900 6,000 Real GDP (b) Contractionary Policy Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. Using Economic Indicators for Fiscal Policy Decision Making • Leading Indicators – Change before the Economy reacts • Co-incident Indicators – Changes with the Economy and Business Cycles. • Lagging Indicators – Change after an event in the Economy Leading Indicators • • • • • • • Consumer Confidence CPI GDP Housing Starts Retail Sales Data PPI Employment Situation Coincident Indicators • Non-agricultural employment • Personal Income • Industrial Production Lagging Indicators • Change in CPI from previous month • Ratio of inventories to sales made • Ratio of consumer credit outstanding to personal income • Average prime rate charged by banks