Chapter 11
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
Roadmap
• Chapter 8-10 establish the theoretical
framework of the macro economy: ASAD equilibrium
• Chapter 11-16 turn to the government
policy
– Fiscal policy (Chapter 11)
– Monetary policy (Chapter 12, 13)
– Debate and trade-off (Chapter 14-16)
Question for This Chapter
• How do taxes (T) affect equilibrium
GDP (Y)?
Tools of Fiscal Policy
• Government spending (G)
• Income Tax (T)
• Government Transfer (GT)
Income Taxes & Consumption Schedule
• Tax affects disposable income (DI = Y-T)
– Real GDP (Y)
– Taxes (T)
5
Income Taxes & Consumption 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
6
Figure 1
How tax policy shifts the consumption schedule
Real Consumer Spending
Tax Cut
C
Tax Increase
Real GDP
7
The Multiplier Revisited
• Change in government purchases G
– Every dollar - spent
– Multiplier effect ( ∆G/∆Y=1/(1-MPC) )
• Change in taxes T
– Not every dollar is spent
– Multiplier – smaller
8
The Tax Multiplier: Fixed Tax
• Increase in G by 1 million
∆Y= 1 + 0.75 + 0.75^2 +0.75^3 + ……
=4
• Decrease in T by 1 million
∆Y= 0.75 + 0.75^2 +0.75^3 + ……
= 0.75(1+0.75+0.75^2+0.75^3+……)
= 0.75*4 = 3
The Tax Multiplier: Variable Tax
• Proportional income tax t=20%
• Increase in G by 1 million
∆Y = 1 + 0.75*(80%) + (0.75*80%)^2
+ (0.75*80%)^3 + ……
= 1 + 0.6 +0.6^2 +0.6^3 + …..
= 1/(1-0.6) = 2.5
∆Y = 1/(1-(1-t)MPC)
The Multiplier Revisited
• Multiplier
– Reduced by income tax
– Income tax
• Reduces - fraction of each dollar of GDP
– Consumers actually receive and spend
• Oversimplified formula 1/(1-MPC)
– Overstates multiplier
1.Ignores variable imports (Chp. 9)
2.Ignores price-level changes (Chp. 10)
3.Ignores income tax
11
Figure 2
The multiplier in the presence of an income tax
45°
Real Expenditure
E1
C+I+G1+(X-IM)
C+I+G0+(X-IM)
$400
E0
0
6,000
7,000
Real GDP
12
The Multiplier Revisited
• Taxes – change multiplier analysis
– Fixed tax changes (T) - smaller multiplier
effect
• Than changes in spending
– Variable income tax (t) - reduces
multipliers for
• Tax changes
• Changes in spending
13
The Multiplier Revisited
• Automatic stabilizer
– Feature of economy
– Reduces its sensitivity to shocks
• Sharp increase/decrease in spending
– Automatically – shock absorber
• Lower multiplier → less volatile
– Example
• Personal income tax
• Unemployment insurance
14
The Multiplier Revisited
• Government transfer payments
– Payments to individuals
• Not compensation for production
– Add to income
– Function as negative taxes
– Net T = taxes - transfers
15
Planning Expansionary Fiscal Policy
• Expansionary fiscal policy
– Raise government purchases (G↑)
– Reduce taxes (T↓)
– Increase transfer payments (GT↑)
• T↓ + GT↑ → Net T↓ → DI=Y - Net T
increase → C ↑
• AD = C + I +G + (X-IM) ↑
• To close recessionary gap
– Between actual and potential GDP
16
Figure 3
Fiscal policy to eliminate a recessionary gap
Potential
GDP
Real Expenditure
45°
Recessionary
gap
45°
F
C+I+G1+(X-IM)
C+I+G0+(X-IM)
E
0
Real Expenditure
Potential
GDP
6,000
7,000
C+I+G0+(X-IM)
0
6,000
7,000
Real GDP
Real GDP
(a)
(b)
17
Figure 4
Expansionary fiscal policy
D1
S
Price Level
D0
Rise in
Price level
A
E
D1
S
Rise in
real GDP
D0
Real GDP
18
Planning Contractionary Fiscal Policy
• Contractionary fiscal policy
– Reduce government purchases (G↓)
– Increase taxes (T↑)
– Reduce transfer payments (GT↓)
• AD = C + I + G + (X-IM) ↓
• To close inflationary gap
– Between actual and potential GDP
• Can avoid inflation
19
Choice: Spending Policy & Tax Policy
• Policy Alternative: G or T
• Case 1: Fixed Taxes (MPC=0.75)
– T 400 Y 1200
– G 400 Y 1600
• Case 2: Variable Taxes (t=20%)
– T 400 Y 750
– G 400 Y 1000
• G↑ directly increases AD; T↓ indirectly
increase AD through consumption
20
Choice: Spending Policy & Tax Policy
• Higher spending, or lower taxes, or a
combination of these two tools
theoretically will achieve
– Same increase in AD curve
– Same increases in real GDP and prices
Choice: Spending Policy & Tax Policy
• In practice, the choice depends on how
large a public sector policy-makers want to
create
• Conservatives  small government 
advocate T (recession) or G (boom)
• Liberals  large government 
advocate G (recession) or T (boom)
22
Some Harsh Realities
• Theory shows gov can drive GDP to any
level they want by using fiscal policy
• Reality is more complicated
– I, X-IM, C schedules
• Shift with
– Expectations (often driven by policy itself),
Technology, Events abroad, Other factors
– Multipliers – not precisely known
– Target - full-employment GDP dimly
visible
– Fiscal policies have time lags
23
Some Harsh Realities
• Legislation level, lower unemployment
rate through G↑ and T↓
– Long-run costs (Chp. 15)
• Running large budget deficits
– Inflationary cost
• How large can we bear
• Seems for expansionary fiscal policy, we
always face a dilemma b/w low
unemployment and high inflation
• Any way out?
24
Idea Behind Supply-Side Tax Cuts
• Supply-side economics believes certain
types of tax cuts
– Increase aggregate supply
• Increase supply of labor & capital
• Reduce inflation
• Raise real GDP
25
Idea Behind Supply-Side Tax Cuts
• Examples of supply-side tax cuts
–  personal income tax rate  stimulate
incentive of working, labor supply ↑
–  tax on income from saving  more
saving  more investment
–  tax on capital gain  stimulate
investment and capital formation
–  corporate income tax
– With more labor and capital supply, AS
curve ↑
Figure 5
The goal of supply-side tax cuts
S0
D
S1
Price Level
A
B
D
S0
S1
Real GDP
28
Figure 6
A successful supply-side tax reduction
D1
S0
D0
S1
A
Price Level
E
C
D1
D0
S0
S1
Real GDP
29
Idea Behind Supply-Side Tax Cuts
• Undesirable side effects
– Small magnitude of supply-side effects
– Stronger demand-side effects
• Tax cut may possibly induce individuals work
more. But they will certainly spend more
– Problems with timing
• Primary short-run effect on AD, effects on AS
come later
– Effects on income distribution
• Increase income equality
– Losses of tax revenue, bigger deficit
30
Figure 7
A more pessimistic view of supply-side tax cuts
D1
S0
D0
Price Level
E
S1
C
D1
D0
S0
S1
Real GDP
31
Summary
• Tools of fiscal policy: G, T and Transfer
• Multiplier for change in T is smaller than that
for change in G
• A proportional income tax t reduces multiplier
• Government transfer acts as a negative tax
• Recessionary gap can be cured by G↑ or T↓
• Inflationary gap can be cured by G↓ or T↑
• Expansionary fiscal policy (G↑ or T↓) can
raise inflation and create budget deficit
• Supply-side tax cuts push AS and hence avoid
the undesirable results of expansionary policy
APPENDIX A
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
33
Figure 8
How variable taxes shift the consumption schedule
Real Consumer Spending
Variable Tax Cut
C
Variable Tax Increase
Real GDP
34
APPENDIX A
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)
35
APPENDIX A
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
• Spending
• Taxing
36
Figure 9
Consumption schedule with fixed vs. variable taxes
Real Consumer Spending
C1
C2
Real GDP
37
Table 1
Effects of an income tax on consumption schedule
(1)
(2)
(3)
(4)
Gross Domestic Product
Taxes
Disposable Income
(GDP minus Taxes)
Consumption
$4,500
5,000
5,500
6,000
6,500
7,000
7,500
$900
1,000
1,100
1,200
1,300
1,400
1,500
$3,600
4,000
4,400
4,800
5,200
5,600
6,000
$3,000
3,300
3,600
3,900
4,200
4,500
4,800
38
Table 2
The relationship between consumption and GDP
With Fixed Taxes
(T=$1,200)
(from Table 1, Chapter 26)
With a 20 percent
Income Tax
(from Table 1)
Y
C
Y
C
$4,800
5,200
5,600
6,000
6,400
6,800
7,200
$3,000
3,300
3,600
3,900
4,200
4,500
4,800
$4,500
5,000
5,500
6,000
6,500
7,000
7,500
$3,000
3,300
3,600
3,900
4,200
4,500
4,800
Line C1 in Figure 9
Line C2 in Figure 9
39
Table 3
Total expenditure schedule with a 20% income tax
(1)
(2)
(3)
(4)
Gross
Domestic
Product
Y
Consumption
C
Investment
I
Government
Purchases
G
$4,500
5,000
5,500
6,000
6,500
7,000
7,500
$3,000
3,300
3,600
3,900
4,200
4,500
4,800
$900
900
900
900
900
900
900
$1,300
1,300
1,300
1,300
1,300
1,300
1,300
(5)
(6)
Net Exports
(X-IM)
Total
Expenditures
C+I+G+(X-IM)
-$100
-100
-100
-100
-100
-100
-100
$5,100
5,400
5,700
6,000
6,300
6,600
6,900
40
Figure 10
Income determination with a variable income tax
45°
Real Expenditure
8,000
C+I+G+(X-IM)
7,000
E
6,000
5,000
4,000
3,000
0
4,000
6,000
Real GDP
8,000
41
APPENDIX A
Multipliers for tax policy
• Tax multiplier for fixed taxes
– Change in tax
• Change in consumer spending
– Vertical shift of consumption schedule
42
Figure 11
The multiplier for a reduction in fixed taxes
45°
Real Expenditure
C1+I+G+(X-IM)
C0+I+G+(X-IM)
$300
billion
6,000
6,750
Real GDP
43
APPENDIX B
Algebraic treatment of fiscal policy
•
•
•
•
•
Y=C+I+G+(X-IM)
C=a+bDI
DI=Y-T
T=T0+tY
C=a-bT0+b(1-t)Y
44
APPENDIX B
Algebraic treatment of fiscal policy
a  bT0  I  G  ( X  IM )
Y
1  b(1  t )
1
Multiplier 
1  b(1  t )
-b
Tax multiplier 
1  b( 1  t)
45