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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
PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
Income Taxes and the C Schedule
• Fiscal policy
– Government’s plan for spending and
taxation
– Designed to steer the aggregate demand
in some desired direction
• Disposable income (DI = Y-T)
– Amount actually available to consumers
– Principal determinant of consumer
spending
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
2
Income Taxes and the C 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
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
3
Figure 1
How Tax Policy Shifts the Consumption Schedule
Real Consumer Spending
Tax Cut
C
Tax Increase
Real GDP
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
4
The Multiplier Revisited
• Change in government purchases
– Every dollar is spent
– Multiplier effect
• Change in taxes
– Not every dollar is spent
– Multiplier – smaller
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
5
The Multiplier Revisited
• Multiplier
– Reduced by income tax
• Income tax reduces the fraction of each
dollar of GDP consumers actually receive
and spend
• Oversimplified formula 1/(1-MPC)
– Overstates multiplier
1.Ignores variable imports
2.Ignores price-level changes
3.Ignores income tax
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
6
Figure 2
The Multiplier in the Presence of an Income Tax
45°
Real Expenditure
E1
C+I+G1+(X-IM)
C+I+G0+(X-IM)
$400
E0
0
6,000
7,000
Real GDP
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
7
The Multiplier Revisited
• Taxes modify the multiplier analysis
– Tax changes have a smaller multiplier
effect than changes in spending
– Income tax reduces multipliers for
• Tax changes
• Changes in spending
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
8
The Multiplier Revisited
• Automatic stabilizer
– Feature of economy that reduces its
sensitivity to shocks
• Sharp increase/decrease in spending
– Automatically act as shock absorbers
• Lower multiplier
– E.g.
• Personal income tax
• Unemployment insurance
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
9
The Multiplier Revisited
• Government transfer payments
– Payments to individuals, not
compensation for production
– Add to income
– Function as negative taxes
– T = Taxes – Transfers
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
10
Planning Expansionary Fiscal Policy
• Expansionary fiscal policy
– Raise government purchases
– Reduce taxes
– Increase transfer payments
• To close recessionary gap
– Between actual and potential GDP
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
11
Figure 3
Fiscal Policy to Eliminate a Recessionary Gap
Potential
GDP
Real Expenditure
45°
Recessionary
gap
45°
F
C+I+G1+(X-IM)
C+I+G0+(X-IM)
E
0
Real Expenditure
Potential
GDP
6,000
7,000
Real GDP
(a)
C+I+G0+(X-IM)
0
6,000
7,000
Real GDP
(b)
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
12
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
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
13
Spending Policy and Tax Policy
• Higher spending and lower taxes
– Same aggregate demand curve
– Same increases in real GDP and prices
• Active fiscal policy
– Smaller public sector
– Larger public sector
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14
Figure 4
Expansionary Fiscal Policy
D1
S
Price Level
D0
Rise in
Price level
A
E
D1
S
Rise in
real GDP
D0
Real GDP
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
15
Spending Policy and Tax Policy
• Advocates of bigger government
– Expand demand: Higher government
spending
– Contract demand: Tax increase
• Advocates of smaller government
– Expand demand: Cut taxes
– Reduce demand: Cut expenditures
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
16
Some Harsh Realities
• Complications
– I, X-IM, C schedules shift with
• Expectations, technology, events abroad,
and other factors
– Multipliers – are not precisely known
– The target of full-employment GDP is only
dimly visible
– Fiscal policies act with time lags
• Must be based on forecasts – may be
inaccurate
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
17
Some Harsh Realities
• To change the unemployment rate
– What are the long-run costs
• Running large budget deficits
– How large is the inflationary cost
• Supply-side economics
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
18
Supply-Side Tax Cuts
• Certain types of tax cuts
– Increase aggregate supply
• Increase supply of labor and 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
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
19
Figure 5
The Goal of Supply-Side Tax Cuts
S0
D
S1
Price Level
A
B
D
S0
S1
Real GDP
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
20
Figure 6
A Successful Supply-Side Tax Reduction
D1
S0
D0
S1
A
Price Level
E
C
D1
D0
S0
S1
Real GDP
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
21
Supply-Side Tax Cuts
• Undesirable side effects
– Small magnitude of supply-side effects
– Demand-side effects
• People will spend more
– Problems with timing
– Effects on income distribution
• Increase inequality
– Losses of tax revenue
• Increase government budget deficit
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22
Figure 7
A More Pessimistic View of Supply-Side Tax Cuts
D1
S0
D0
Price Level
E
S1
C
D1
D0
S0
S1
Real GDP
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
23
Supply-Side Tax Cuts
• Conclusions
– Effectiveness of supply-side tax cuts
depends on what kinds of taxes are cut
• Stimulate business investment - greater
impact
– Increase aggregate supply more slowly
than they increase aggregate demand
• Slightly faster economic growth in long run
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
24
Supply-Side Tax Cuts
• Conclusions
– Demand-side effects are likely to
overwhelm supply-side effects in the short
run
– Likely to widen income inequalities
– Lead to larger budget deficits
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
25
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
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
26
Figure 8
How Variable Taxes Shift the Consumption Schedule
Real Consumer Spending
Variable Tax Cut
C
Variable Tax Increase
Real GDP
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
27
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)
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
28
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 how much spending and
taxing it does
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
29
Figure 9
The Consumption Schedule with Fixed vs. Variable Taxes
Real Consumer Spending
C1
C2
Real GDP
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
30
Table 1
The Effects of an Income Tax on the Consumption
Schedule
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
31
Table 2
The Relationship between Consumption and GDP
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
32
Table 3
Total Expenditure Schedule with a 20 Percent Income Tax
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
33
Figure 10
Income Determination with a Variable Income Tax
45°
Real Expenditure
8,000
C+I+G+(X-IM)
7,000
E
6,000
5,000
4,000
3,000
0
4,000
6,000
8,000
Real GDP
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
34
Multipliers for tax policy
• Tax multiplier for fixed taxes
– Change in tax
• Change in consumer spending
– Vertical shift of consumption schedule
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
35
Figure 11
The Multiplier for a Reduction in Fixed Taxes
45°
Real Expenditure
C1+I+G+(X-IM)
C0+I+G+(X-IM)
$300
billion
6,000
6,750
Real GDP
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
36
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
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
37
Algebraic treatment of fiscal policy
a  bT0  I  G  ( X  IM )
Y
1  b(1  t )
1
Multiplier 
1  b(1  t )
-b
Tax multiplier 
1  b( 1  t)
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
38