1. Managing Aggregate Demand: Fiscal Policy11

2. Issues with Fiscal Policy
Can the government manage the economy better than the self correction mechanism?
Fiscal policy
Government spending (G) and taxation (T)
Intent is to steer/stabilize aggregate demand
Debates over fiscal policy
Multiplier effects of tax cuts (T) versus more spending(G)
Multiplier effects of different tax cuts
Incentive effects of different tax cuts

3. Income Taxes and the Consumption Schedule
How do taxes effect equilibrium GDP?
Disposable income (DI = Y-T)
Amount actually available to consumers
Principal determinant of consumer spending
How does a change in taxes affect the consumption function?

4. Figure 1 How Tax Policy Shifts the Consumption Schedule Tax Cut C
Real Consumer Spending C
Tax Increase
Real GDP

5. Income Taxes and the C Schedule
A change in taxes has a multiplier effect on GDP
Lower taxes increase GDP by a multiple of the tax change
Higher taxes decrease GDP by a multiple of the tax change
Difference between more government spending and lower taxes
Higher spending increases real GDP directly
Lower taxes increase real GDP indirectly

6. The Multiplier Revisited
Increase in G example: ΔG = $1 million and MPC = 0.75
ΔY = $1,000,000 + $750,000 + $562,
ΔY = $1 mill x [ ]
ΔY = $1 mill x 4
ΔY = $4 mill
With a tax cut
First round of spending is only $750,000
ΔY = $750,000 + $562,
ΔY = $750,000 x 4 = $3 million
The multiplier effect is smaller!
Tax changes have a smaller multiplier effect than changes in spending

7. The Multiplier Revisited
Income taxes and the multiplier
Now suppose that the income tax rate (t) = 20%, i.e. t = 0.20
For every dollar of Y you earn, you must give $0.20 to the government.
When G increases by $1 million, disposable income increases by $800,000 (NOT $1 million)
You don’t get: ΔY = $1 mill x [ ]
You get : ΔY = $1 mill x [ ]
0.6 = 0.75 x ( )
Multiplier = 1/(1 – 0.60) = 2.5
The formula for the spending multiplier becomes −𝑚𝑝𝑐(1−𝑡)

8. The Multiplier Revisited
Simple multiplier reduced by income tax
Income tax reduces the fraction of each dollar of GDP consumers actually receive and spend
We have now discussed three reasons why simple multiplier is simple
Ignores variable imports – Chapter 9
Ignores price-level changes – Chapter 10
Ignores income tax – Chapter 11

9. Figure 2 The Multiplier in the Presence of an Income Tax
45°
Real Expenditure
C+I+G1+(X-IM) E1
7,000
C+I+G0+(X-IM)
With tax rate of 20%,
ΔY = $400 x 2.5 = $1000
$400
6,000 E0
Without taxes,
ΔY = $400 x 4 = $1,600
Real GDP

10. The Multiplier Revisited
Taxes modify the multiplier analysis
Tax changes have a smaller multiplier effect than changes in spending
Income tax reduces multipliers for both tax changes, and changes in spending

11. The Multiplier Revisited
Automatic stabilizer
Feature of economy that reduces its sensitivity to shocks: sharp increases or decreases in spending
Acts as a shock absorber reducing the multiplier effect
Personal income tax (which we just looked at), unemployment insurance

12. The Multiplier Revisited
Government transfer payments
Payments to individuals, not compensation for production
DI = Y – Taxes + Transfer payments
Transfer payments function as negative taxes
Transfer payments have a smaller multiplier effect than spending .
The multiplier formula for transfer payments is
𝑚𝑝𝑐 1−𝑚𝑝𝑐(1−𝑡)

13. Planning Expansionary Fiscal Policy
Suppose that real GDP is below potential. What three policies would close the recessionary gap?

14. Planning Expansionary Fiscal Policy
Suppose that real GDP is below potential. What three policies would close the recessionary gap?
Expansionary fiscal policy
Increase government purchases
Reduce taxes
Increase transfer payments

15. Figure 3 Fiscal Policy to Eliminate a Recessionary Gap 7,000 Potential
GDP
7,000
Potential
GDP
Real Expenditure
Real Expenditure
45°
45°
Recessionary
gap
C+I+G1+(X-IM) F
C+I+G0+(X-IM) E
C+I+G0+(X-IM)
6,000
Real GDP
Real GDP
6,000
(a)
(b)

16. Planning Expansionary Fiscal Policy
The previous slide showed a recessionary gap of $7,000. Suppose the MPC is 0.75 and t = 0.20.
Expansionary fiscal policy
What increase in G is needed to close the gap?
What increase in transfer payments is needed to close the gap?

17. Planning Contractionary Fiscal Policy
Suppose that real GDP is above potential. What do you do?
Contractionary fiscal policy
Reduce government purchases
Increase taxes
Reduce transfer payments
How is this different than the self-correction mechanism?
With self-correction, gap eliminated as inflation increases
With policy, can limit inflation by reducing aggregate demand

18. Choice between Spending and Tax Policy
Higher spending and lower taxes in AD-AS model
Any combination will increase aggregate demand
Lower spending and higher taxes in AD-AS model
Any combination will decrease aggregate demand

19. Expansionary Fiscal Policy
Figure 4
Expansionary Fiscal Policy
AD1
SRAS
AD0
Price Level A
Rise in
Price level E
Rise in
real GDP
Real GDP

20. Choice between Spending and Tax Policy
How do you decide which to use: T or G?
Advocates of smaller government
Private individuals and firms do things better than public sector
Cut taxes to expand demand
Cut spending to contract demand

21. Choice between Spending and Tax Policy
Advocates of bigger government
Need larger public sector, since important needs not met by private sector
Increase spending to expand demand
Increase taxes to contract demand

22. Some Harsh Realities Complications
Expectations, technology, events abroad, and other factors constantly shift expenditure functions
Multipliers not precisely known
Full-employment GDP difficult to measure
Fiscal policies act with time lags
Politicians are in charge

23. Problems and Complication With Fiscal Policy
7,000
Potential
GDP
Real Expenditure
45°
Full-employment GDP difficult to measure
Recessionary
gap is a guess
C+I+G0+(X-IM)
Expectations, technology, events abroad, and other factors constantly shift expenditure functions – AE is not stable or predictable
Real GDP
6,000
(a)

24. Other issues to address when pursue expansionary policy
Some Harsh Realities
Other issues to address when pursue expansionary policy
What are the long-run costs of large budget deficits
How large is the inflationary cost

25. Supply-side Economics: Supply-Side Tax Cuts
Central idea of supply-side economics
Certain types of tax cuts increase aggregate supply
Tax cuts increase the reward for working, saving, investing therefore results in greater incentive to work, save and invest
SRAS shifts to the right

26. The Goal of Supply-Side Tax Cuts
Greater aggregate supply will increase GDP and decrease the price level
SRAS0 AD
Price Level
SRAS1 A B
Real GDP

27. Supply-Side Tax Cuts Supply-side policies
Lower personal income tax rates
Reduce taxes on income from savings
Reduce taxes on capital gains
Reduce the corporate income tax
Both AD and AS shift to the right
If policies work may be able to avoid inflationary consequences of expansionary policy

28. A Successful Supply-Side Tax Reduction Price level at Point C is less than Point A
AD1
SRAS0
AD0
Price Level
SRAS1 A E C
Real GDP

29. Supply-Side Tax Cuts Flies in the ointment
Small magnitude of supply-side effects
Incentive effects on savings likely to be small
Demand-side effects
Rather than working more, people spend more
The shift in AS to the right may be small

30. A More Pessimistic View of Supply-Side Tax Cuts higher increase in price and lower increase in RGDP
Price Level S1 C E
Real GDP

31. Supply-Side Tax Cuts Flies in the ointment Problems with timing
Effects on income distribution and increase inequality
Losses of tax revenue increase budget deficit

32. 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
Better for long-run growth policy than short-run stabilization policy

33. 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

34. Graphical Treatment of Taxes and Fiscal Policy
Variable taxes are taxes that change with GDP
Personal income tax, corporate income tax, sales tax
Fixed taxes do not change with GDP
Property taxes
How do the different taxes change shifts in and slope of the consumption line?

35. Figure 9 The Consumption Schedule with Fixed vs. Variable Taxes
Real Consumer Spending C2
Variable taxes flatten the consumption schedule
Real GDP

36. Table 1
The Effects of an Income Tax on the Consumption Schedule

37. Table 2
The Relationship between Consumption and GDP

38. Table 3
Total Expenditure Schedule with a 20 Percent Income Tax

39. Figure 10 Income Determination with a Variable Income Tax 3,000 4,000
5,000
6,000
7,000
Real Expenditure
8,000
45°
C+I+G+(X-IM) E
4,000
6,000
Real GDP
8,000

40. Algebraic Treatment of Fiscal Policy
Find equilibrium GDP when: I = 900, G = 1,300, (X – IM) = -100, tax rate = 20%
Y= C + I + G + (X – IM)
T = 0.20Y
C = DI
DI = Y – T
C = (Y – 0.20Y) = Y
Y = Y – 100
0.40Y = 2,400
Y = 6,000

41. Algebraic Treatment of Fiscal Policy
Equilibrium condition Y = C + I + G + (X - IM) (1)
Consumption function C = a + bDI (2)
Disposable income DI = Y – T (3)
Tax function T = T0 + tY (t is the tax rate) (4)
Plug (3) and (4) into (2)
C = a - bT0+ b(1-t)Y (5)
Plug (5) into (1)
Y = a - bT0+ b(1-t)Y + I + G + (X - IM)

42. Algebraic Treatment of Fiscal Policy
Y = a - bT0+ b(1-t)Y + I + G + (X - IM)
Finally, solve for Y
What are the spending and tax multipliers with variable taxes?

43. Multipliers for Tax Policy
What happens if the tax cut is $400, the MPC = 0.75 and t = 0.20?

44. Figure 11 The Multiplier for a Reduction in Fixed Taxes
Real Expenditure
45°
C1+I+G+(X-IM)
6,750
C0+I+G+(X-IM)
6,000
$ -400 x
Real GDP