Demand-Side Policy:
Greater Spending
Means Higher Prices
Price Level
(c) Aggregate Demand and Supply in
the classical range of AS curve. (Prices
rise without significant improvements
in output and employment.)
AD1
AD
Y?
Real GDP
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Analysis of a
Tax-and-Spend
Policy
Government
increases
spending, but
finances it with
tax increases. The
increase in
spending shifts
AD to the right,
but the increase
in taxes reduces
the incentive to
work(???),
shifting AS to the
left.
2
Crowding Out
Government Deficit  Borrowing by
Government
 Government Demand for Credit 
Interest Rates UP.
 Higher interest rates  Investment
Spending DOWN

investment is “crowded
out” by debt-financed public (gov’t)
spending.
 Private
3
Other impacts of
Budget Deficits and National Debt

Crowding out of private investment 
Future capital stock DOWN  Future
Output DOWN .

Interest rates UP  Currency Appreciation
 Foreign Goods Cheaper  Imports UP
 Net Exports DOWN  GDP DOWN

National Debt UP Interest paid by
government UP.
4
U.S. Government
Revenues and
Expenditures
5
U.S. Government Expenditures
as a Percentage of GDP
6
7
Fiscal Policy: Some Definitions




Demand-side policies: spending and tax
policies designed to stimulate or slow
aggregate demand.
Supply-side policies: policies designed to
increase productivity and enterprise.
Discretionary Fiscal Policy: changes in
government spending and/or taxation aimed at
achieving a policy goal.
Automatic Stabilizer: an element of fiscal policy
that changes automatically as income changes.
8
Automatic Stabilizers

Progressive Taxes
–

As income falls, the tax rate also falls,
helping to maintain buying power and
hence aggregate demand
Transfer Payments
–
–
Examples: Unemployment insurance,
welfare, subsidies
Insure that buying power is not reduced at
the same rate as income
9
Taxes: Some Definitions

Direct taxes: on individuals and firms.

Examples: income taxes and value-added
taxes (VAT).
Indirect taxes: on goods and services
 Tax rate structures:

–
–
–
progressive tax: rate increases with higher
income.
regressive tax: rate falls with higher income.
proportional tax: rate is constant.
10
Central Government Spending by
Functional Category
11
Supply-Side
Economics
and the
Laffer
Curve
•Taxes are a
disincentive to
productive activity.
•At marginal tax rates
greater than t, the tax
base shrinks at a
faster rate than the
increases in marginal
tax rate.
•Net result: increases
in marginal tax rates
beyond t result in
reduced tax revenues.
12
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