+ Analyze the features of the US’s tax system to understand how it works to stabilize the economy Explain and understand the loanable funds market/crowding out effect Tax Systems & Market for Loanable Funds

+ Discussion Question: Analyze and evaluate the following statement: “Using monetary or fiscal policy to pump up the economy is counterproductive—you get a brief high, but then you have the pain of inflation.” 1. Explain in terms of AD-AS model. 2. Valid argument against stabilization policy?

+ Answer: 1. An increase in AD, regardless of what type of expansionary policy is enacted, in order to close a recessionary gap may eliminate high levels of unemployment and increase GDP; however, the increase in aggregate price level (inflation) that occurs as a result is a negative side-effect. 2. Not a valid argument. Whenever the SR equilibrium is not at LR full-employment level of output as a result of some type of decline in AD, any discretionary monetary or fiscal policy put in place to close an inflationary gap will return the economy back to prerecession level price level and output.

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+ Progressive, Regressive, and Proportional Tax Systems Progressive: takes greater percentage of income from high- income groups than low-income groups Regressive: takes a greater percentage of income from low- income groups than high-income groups Proportional: takes the same percentage of income from all groups regardless of level of income Vertical Equity: concept that people in different income groups should pay different rates of taxes or different percentages of their incomes as taxes. “Unequals should be taxed unequally”

+ Progressive, Regressive, and Proportional Tax Systems TAX COLLECTED INCOME PP PG RG

+ Examine the Outcomes: INCOMETAX RATE (PROG.) TAX RATE (REG.) TAX RATE (PROP.) $10,00010%20% $50,00020%5%20% $100,00030%2%20% 1.Total revenue generated in A.) Progressive? B.) Regressive? C.) Proportional? 2. What is the “fairest” system? 3.Include the concept of MPC/MPS in your analysis. Why do we have the tax system that we do? ***What type of tax is…FICA? Sales tax?

+ Progressive Tax System Features SELF STABILIZING!!!! Tax rates vary with income level In periods of SR expansion/contraction (recessionary or inflationary gaps) GDP, thus income increases or decreases Income increase (inflationary) tax rate increases, reducing disposable income block, thus decreasing AD in the SR Vice versa holds true as well Automatically works to close positive and negative output gaps According to the National Bureau of Economic Research this feature of out tax system “offset perhaps as much as 8 percent of initial shocks to GDP.”

+ Automatic Stabilizer: Transfer Payments Unemployment insurance benefits, food stamps, temporary assistance for needy families, housing & energy assistance to low income families, automatically increase during a recession: Supports consumption spending and aggregate demand, which offset the decline in economic activity. During economic prosperity, tax collections automatically rise and transfer payments automatically decline Automatic stabilizers are not strong enough to completely eliminate recessionary or inflationary gaps Measures occur free from government approval or disapproval & they are constantly working to move economy to LREQ Remember: Fiscal Policy Components

+ Crowding-Out Effect Occurs when government wants to increase spending (G  ) and needs to borrow money to do so…deficit spending Money borrowing occurs in the loanable funds market Main Idea: as G borrows more money, they are artificially driving up interest rates As interest rates increase, firms/households invest less in durable goods Ultimately, a bump in G will not have the assumed effect on output that people assume because of the decrease in I that will occur in theory Highly debated theory with many speculated circumstances and outcomes based on specific market factors

+ Crowding-Out Effect Loanable Funds Market creates a model for us to analyze how changes in interest rates will affect the demand and supply of money Who demands money? Households: houses, cars, education, ect. Firms: investment in capital Governments: any expenditure not covered by tax revenue Foreign markets: their market’s interest rates higher that another *Note: The loanable funds market has been on 3 of the last 5 AP FRQ sections…

+ Loanable Funds Market Illustrated Need to know this model! Governed by the same principles as Micro S/D model Supply of Loanable Funds (LFS) Demand of Loanable Funds (LFD) Loanable Funds Equilibrium (LFE) Interest Rate Quantity of $ LFS LFD  R Q LFE

+ Crowding Out Effect Illustrated As G borrows more, demand for money increases (LFD  ) LFD shifts right, quantity of $ demanded increases, and INTEREST RATES INCREASE Interest Rate LFS LFD  R Q LFE LFD 2  LFE 2 Quantity of $

+ Quick Quiz 1. What are the 3 forms of expansionary fiscal policy? 2. What are the 3 forms of contractionary fiscal policy? 3. What is the goal of macroeconomic policy? 4. Illustrate the crowding out effect in the loanable funds market.