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27
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
Contents
● Income Taxes and the Consumption
Schedule
● The Multiplier Revisited
● Planning Expansionary Fiscal Policy
● Planning Contractionary Fiscal Policy
● The Choice Between Spending Policy and
Tax Policy
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Contents (continued)
● Some Harsh Realities
● The Idea Behind Supply-Side Tax Cuts
● Appendix: Algebraic Treatment of Fiscal
Policy and Aggregate Demand
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Income Taxes and the
Consumption Schedule
●  taxes 
♦  consumption
♦  AD
● Fixed taxes = taxes that do not vary with
GDP
♦  parallel shift down in the consumption
function
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Income Taxes and the
Consumption Schedule
● Variable taxes = taxes that do vary with
GDP
♦  flattens the consumption schedule
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27-1 How Tax Policy
Shifts the Consumption Schedule
Fixed tax cut
C
Fixed tax
increase
Variable tax cut
Real Consumer Spending
Real Consumer Spending
FIGURE
C
Variable tax
increase
Real GDP
Real GDP
(a)
(b)
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Income Taxes and the
Consumption Schedule
●  government purchases of goods and
services   total spending directly
through the G component of C + I + G + (X
- IM).
●  taxes   total spending indirectly by
lowering disposable income and, thus,
reducing the C component of C + I + G +
(X - IM).
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27-2 The Consumption
Schedule, Fixed & Variable Taxes
FIGURE
Real Consumer Spending
C1
C2
Real GDP
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27-1 Effects of Income
Tax on Consumption Schedule
TABLE
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27-2 The Relationship
between Consumption and GDP
TABLE
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Income Taxes and the
Consumption Schedule
● On balance, the government’s actions may
raise or lower equilibrium GDP, depending
on how much spending and taxing it does.
● income tax   multiplier
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The Multiplier Revisited
● Variable tax   multiplier
♦ When incomes rise, a larger amount is taken
out in taxes than before, leaving a smaller
increase in disposable income.
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27-4 The Multiplier in the
Presence of an Income Tax
FIGURE
45
C + I + G1 + (X – IM)
Real Expenditure
E1
C + I + G0 + (X – IM)
$400
E0
6,000
7,000
Real GDP
8,000
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The Multiplier Revisited
● Reasons why the oversimplified multiplier
formula overstates the size of the multiplier:
♦ Ignores variable imports
♦ Ignores price-level changes
♦ Ignores income taxes
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The Multiplier Revisited
● Automatic stabilizers
♦ Automatic stabilizers = features of the
economy that reduce its sensitivity to shocks
■Personal income tax
■Unemployment insurance
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The Multiplier Revisited
● Multipliers for Tax Policy
♦ Multiplier for  T < Multiplier for  G
■G affects AD directly
■T changes only disposable income
■Resulting  consumption <  disposable income
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The Multiplier Revisited
● Multipliers for Tax Policy
♦ If G and T increase by the same amount, the
effects do not cancel out.
■ G   GDP
■ T   GDP
■Because G’s multiplier is larger, the net effect will
be an increase in GDP.
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The Multiplier Revisited
● Moral: Fiscal policies that keep the deficit
(G - T) constant do not keep AD constant.
♦ If spending increases are financed by tax
increases, the economy will expand.
♦ If tax cuts are financed by spending cuts, the
economy will contract.
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The Multiplier Revisited
● Government Transfer Payments
● Transfers = payments to individuals that do
not compensate them for any direct
contribution to production
● Transfers are the analytical equivalent of
negative taxes.
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Planning Expansionary
Fiscal Policy
● Three types of fiscal policy can be used to
stimulate the economy:
♦G
♦T
♦  Transfer payments
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27-6 Fiscal Policy to
Eliminate a Recessionary Gap
FIGURE
E
Potential
GDP
45
C + I + G0 +
(X – IM)
Real Expenditure
Real Expenditure
Potential
GDP
45
F
C + I + G1 +
(X – IM)
C + I + G0 +
(X – IM)
Recessionary
gap
5,000
6,000
7,000
Real GDP
(a)
5,000
6,000
7,000
Real GDP
(b)
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Planning Contractionary
Fiscal Policy
● Three types of fiscal policy can be used to
slow the economy:
♦G
♦T
♦  Transfer payments
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Planning Contractionary
Fiscal Policy
● Note that the self-adjusting mechanism will
eventually perform the same task, but at the
cost of more inflation than will occur if the
government succeeds in reducing AD.
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The Choice Between
Spending and Tax Policy
● The choice between G and T reflects a
difference in opinion about the desirable
size of the government sector.
♦ Advocates of small government prefer:
■To lower T in order to stimulate output
■To lower G to control inflation
♦ Advocates of big government prefer:
■There is nothing about an activist fiscal policy that
implies a preference for big government.
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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
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Some Harsh Realities
● A fiscal policy planner’s job is not simple.
♦ Economic variables change continuously.
♦ The “policy target” is constantly moving.
♦ Economists have only an uncertain knowledge
of the value of the multiplier and the fullemployment level of GDP.
♦ Forecasts are uncertain and policies take time
to work.
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The Idea Behind Supply-Side
Tax Cuts
● Supply-side economics = idea that  taxes
  AS 
♦  GDP
♦  price level
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27-8 The Goal of SupplySide Tax Cuts
FIGURE
S0
S1
Price Level
D
A
B
S0
S1
D
Real GDP
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27-9 A Successful
Supply-Side Tax Reduction
FIGURE
D1
S0
S1
Price Level
D0
A
C
E
D1
S0
S1
D0
Real GDP
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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
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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
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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
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Toward Assessment of
Supply-Side 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.
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Appendix: Algebraic
Treatment of Fiscal
Policy and Aggregate
Demand
Algebraic Treatment
● Multiplier for G, I, a, or (X - IM) with
variable taxes = 1  1 - b(1 - t).
● The higher the rate of variable taxation, the
lower the multiplier.
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