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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 © 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. 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 © 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. 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 © 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. 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 © 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. 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 © 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. 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 © 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. 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 © 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. 31 Table 2 The Relationship between Consumption and 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. 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 © 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. 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