University:
California State University, Northridge
Course:
ECON 500 | Survey of Economics
Academic year:

2024
Views:

183

Pages:

25
Author:

Leland Mcdonald

Managing Aggregate Demand: Fiscal Policy Contents ● Great Fiscal Stimulus Debate ● Income Taxes & the Consumption Schedule ● The Multiplier Revisited ● Planning Fiscal Policy ● Choice Between Spending Policy & Tax Policy ● Some Harsh Realities ● Supply-Side Tax Cuts Great Fiscal Stimulus Debate of 2009-10 ● Has the $787B stimulus worked? ● Republicans: No ♦ Too much spending ♦ Not enough tax cuts ♦ ↑budget deficit ● Democrats: Yes ♦ ↑AD and moderated the recession ♦ ↑G impacts the economy sooner and with more certainty than ↓T Income Taxes & Consumption Schedule ● Fiscal policy ♦ Government’s plan for spending & taxation ♦ Shift AD in desired direction ● Disposable income (DI = Y-T) ♦ Where Y = Real GDP and T = Taxes Income Taxes & Consumption Schedule ● Tax increase ♦ C f(x) and expenditure schedule shift downward ♦ Equilibrium GDP (on the demand side) is decreased ● Tax decrease ♦ C f(x) and expenditure schedule shift upward ♦ Equilibrium GDP (on the demand side) is increased FIGURE 1. How tax policy shifts the consumption schedule Real Consumer Spending Tax Cut C Tax Increase Real GDP The Multiplier Revisited ● ∆ in G ♦ Impacts spending directly ■ through G component of C + I + G + X – IM ● ∆ in T ♦ Impacts spending indirectly– through C component ♦ Unlike G, not every dollar is spent, some is saved ♦ So the multiplier is smaller for T than for G The Multiplier Revisited ● Multiplier ♦ Reduced by income tax ♦ Income tax reduces the fraction of each dollar of GDP that consumers actually receive and spend ● Oversimplified multiplier of 1/(1-MPC) ♦ Overstates the economy’s actual multiplier 1. Ignores variable imports 2. Ignores price-level changes 3. Ignores income tax The Multiplier Revisited ● Two ways taxes modify the multiplier analysis: 1. Tax changes have a smaller multiplier effect than spending changes by gov or others. 2. An income tax reduces the multipliers for both tax changes and changes in spending. The Multiplier Revisited ● Automatic stabilizer: feature of the economy that reduces its sensitivity to shocks ● Changes in spending components (C, I, G, or X-IM) occur all the time and they drive GDP up or down by a multiplied amount. ♦ If the multiplier is smaller → GDP is less sensitive to shocks and the economy is less volatile ● Ex.: personal income tax ♦ Taxes make DI and thereby C less volatile ■ E.g., If ↑Y, ↑DI less sharply because part of the rise is absorbed by the gov which helps limits any ↑C The Multiplier Revisited ● UI is also an automatic stabilizer ♦ If ↓GDP and ↑UE → UI prevents DI from fallings as dramatically as earnings ♦ UE can maintain their spending better, so C fluctuates less than employment does ● Automatic stabilizers act as shock absorbers and therefore lower the multiplier ♦ Stabilizers (like taxes or UI) work automatically without the need for gov action The Multiplier Revisited ● Gov transfer payments ♦ Payments to individuals and not compensation for production ♦ Intervene between GDP and DI in exactly the opposite way from income taxes ■ Add to earned income (rather than subtract from it) ■ Function as negative taxes Planning Fiscal Policy ● Expansionary fiscal policy ♦ ↑G, ↓taxes or ↑transfer payments ♦ To close recessionary gap between actual and potential GDP ● Contractionary fiscal policy ♦ ↓G, ↑taxes or ↓transfer payments ♦ To close inflationary gap between actual and potential GDP Choice: Spending Policy & Tax Policy ● Any combination of higher spending and lower taxes that produces the same AD curve leads to the same increases in real GDP and prices ● So should policy makers use ↑G or ↓T to ↑AD? ♦ How large a public sector do they want? ♦ Conservatives argue for smaller government ■ Reduces taxes during recessions and cut spending during booms ♦ Liberals argue for larger government ■ Increase spending during recessions and raise taxes during booms FIGURE 2. Expansionary fiscal policy D1 S Price Level D0 Rise in Price level A E D1 S Rise in real GDP D0 Real GDP 72 Some Harsh Realities ● Why can’t fiscal policy drive GDP to its fullemployment level? ● C, I, and X-IM schedules shift abruptly with changes in expectations, technology, and events abroad, etc. ● Multipliers are unknown ● What is the full-employment level of GDP? ● Time lag between fiscal policies and their impact on spending ● Congress members (not economists) enact “political” fiscal policies Some Harsh Realities ● Should policy makers work to push UE lower? ♦ ↑G or ↓T will ↑deficits; What are the LR costs of running large budget deficits? ♦ How large will the inflationary cost be? ● If costs are large, then gov may be hesitant to use fiscal policy to fight recessions. ● “Supply-side” economics ♦ Battle UE without sparking inflation Idea Behind Supply-Side Tax Cuts ● Certain types of tax cuts ♦ Shift AS out which can ↓inflation and ↑real GDP ♦ Raise the returns to working, saving and investing ■ If people respond → ↑SL and ↑SK ● Supply-siders typically advocate tax cuts on: ♦ Personal income ♦ Income from savings ♦ Capital gains ♦ Corporate income FIGURE 3. The goal of supply-side tax cuts S0 D S1 Price Level A B S0 D S1 Real GDP 76 FIGURE 4. A successful supply-side tax reduction D1 S0 D0 A Price Level E S1 A successful supply-side tax cut will shift both AD and AS. C D1 S0 D0 S1 Real GDP 77 Idea Behind Supply-Side Tax Cuts ● Some complications and undesirable side effects ♦ Small magnitude of supply-side effects ■ People may not save more in response to tax incentives. ■ Charles Schultz: “There’s nothing wrong with supply-side economics that division by 10 couldn’t cure.” ♦ Demand-side effects ■ People may work more but they will certainly spend more. ● Figure 5 (rather than Figure 4) may better represent the impact of supply-side policies on AD and AS. FIGURE 5. A more pessimistic view of supply-side tax cuts D1 D0 S0 Price Level E S0 S1 A supply-side tax cut may shift AD much more than AS. C D0 D1 Inflation now rises as it did under “demandside” fiscal stimulus in Figure 2. S1 Real GDP 79 Idea Behind Supply-Side Tax Cuts ● Further complications ♦ Problems with timing ■ I incentives are the most promising supply-side tax cuts but it may take years before we see the impact on GDP. ♦ Effects on income distribution ■ Reductions in personal income-tax rates and capital gains taxes increase income inequality. ♦ Losses of tax revenue ■ Tax cuts raise the budget deficit. ● 15 years to overcome the deficits created by Reagan’s tax cuts Idea Behind Supply-Side Tax Cuts ● Effectiveness of supply-side tax cuts? ♦ Tax cuts to raise business I – have the greatest impact ♦ Increase AS more slowly than AD ■ Leads to faster economic growth in LR but is not a substitute for SR stabilization policy ♦ Demand-side effects overwhelm supply-side effects in SR ♦ Likely to widen income inequalities ♦ Lead to larger budget deficits Great Fiscal Stimulus Debate of 2009-10 ● Both political parties wanted to stimulate the economy in 2009 but Republicans wanted less G and more T cuts. ● Democrats argued that the supply-side effects of Republican-proposed tax cuts are small and uncertain and that the economy has too little AD (not too little AS). ● Republicans countered that business tax incentives are the best way to spur LR job creation and that the fiscal multiplier is small or even zero.

Managing Aggregate Demand: Fiscal Policy

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