PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University 1 © 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. 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

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 2 © 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.

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 3 © 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.

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

The Multiplier Revisited Change in government purchases –Every dollar is spent –Multiplier effect Change in taxes –Not every dollar is spent –Multiplier – smaller 5 © 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.

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 6 © 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.

Figure 2 The Multiplier in the Presence of an Income Tax 7 0 Real GDP Real Expenditure 45° 6,000 C+I+G 0 +(X-IM) E0E0 C+I+G 1 +(X-IM) 7,000 $400 E1E1 © 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.

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 8 © 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.

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 9 © 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.

The Multiplier Revisited Government transfer payments –Payments to individuals, not compensation for production –Add to income –Function as negative taxes –T = Taxes – Transfers 10 © 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.

Planning Expansionary Fiscal Policy Expansionary fiscal policy –Raise government purchases –Reduce taxes –Increase transfer payments To close recessionary gap –Between actual and potential GDP 11 © 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.

Figure 3 Fiscal Policy to Eliminate a Recessionary Gap 12 0 Real GDP Real Expenditure 45° 6,000 C+I+G 0 +(X-IM) 7,000 Potential GDP (a) Real Expenditure 45° 0 Real GDP 6,000 C+I+G 0 +(X-IM) 7,000 Potential GDP (b) C+I+G 1 +(X-IM) F E Recessionary gap © 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.

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 13 © 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.

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 14 © 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.

Figure 4 Expansionary Fiscal Policy 15 Real GDP Price Level D0D0 D0D0 S S D1D1 D1D1 A E Rise in real GDP Rise in Price level © 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.

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 16 © 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.

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 17 © 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.

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 18 © 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.

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 19 © 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.

Figure 5 The Goal of Supply-Side Tax Cuts 20 Real GDP Price Level D D S0S0 S0S0 A S1S1 S1S1 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.

Figure 6 A Successful Supply-Side Tax Reduction 21 Real GDP Price Level D0D0 D0D0 S0S0 S0S0 E S1S1 S1S1 D1D1 D1D1 A C © 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.

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 22 © 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.

Figure 7 A More Pessimistic View of Supply-Side Tax Cuts 23 Real GDP Price Level D0D0 D0D0 S0S0 S0S0 E S1S1 S1S1 D1D1 D1D1 C © 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.

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 24 © 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.

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 25 © 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.

Appendix 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 26 © 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.

Figure 8 How Variable Taxes Shift the Consumption Schedule 27 Real GDP Real Consumer Spending C Variable Tax Increase Variable Tax Cut © 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.

Appendix 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) 28 © 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.

Appendix 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 29 © 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.

Figure 9 The Consumption Schedule with Fixed vs. Variable Taxes 30 Real GDP Real Consumer Spending C1C1 C2C2 © 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.

Table 1 The Effects of an Income Tax on the Consumption Schedule 31 © 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.

Table 2 The Relationship between Consumption and GDP 32 © 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.

Table 3 Total Expenditure Schedule with a 20 Percent Income Tax 33 © 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.

Figure 10 Income Determination with a Variable Income Tax 34 4,0000 6,000 Real GDP 8,000 3,000 4,000 5,000 6,000 7,000 Real Expenditure 8,000 45° C+I+G+(X-IM) E © 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.

Appendix Multipliers for tax policy Tax multiplier for fixed taxes –Change in tax Change in consumer spending –Vertical shift of consumption schedule 35 © 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.

Figure 11 The Multiplier for a Reduction in Fixed Taxes 36 Real GDP Real Expenditure 45° C 0 +I+G+(X-IM) 6,000 C 1 +I+G+(X-IM) 6,750 $300 billion © 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.

Appendix Algebraic treatment of fiscal policy Y=C+I+G+(X-IM) C=a+bDI DI=Y-T T=T 0 +tY C=a-bT 0 +b(1-t)Y 37 © 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.

Appendix Algebraic treatment of fiscal policy 38 © 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.