Chapter 27 Managing Aggregate Demand: Fiscal Policy

Transcription

1 Chapter 27 Managing Aggregate Demand: Fiscal Policy 1. (a) If the defense cuts are used to reduce the government deficit, that is to say, if total government spending falls by the amount of the military reductions and if taxes are not cut, GDP will fall by a multiplied amount. (Note to instructors: Later chapters will show that an expansive monetary policy may compensate for this reduction in government spending, resulting in a modified or zero decline in GDP.) 2. (b) If government spending is switched from the military to other purchases, total G will not fall, and GDP will not be affected FIGURE 27-1 Equilibrium GDP is The marginal propensity to consume is 0.75 and the multiplier is 4. If government purchases fell by 60, and the price level were unchanged, GDP would fall by 4360, or 240, to 1480.

2 FIGURE 27-2 Compared to Question 2, the expenditure line has a flatter slope, but it still crosses the 45-degree line at a GDP of The marginal propensity to consume is still Now, however, the marginal tax rate is 1/3 (that is, when income rises by 3, taxes rise by 1). Consequently the multiplier falls to 2. A reduction in G of 60 will lower equilibrium GDP by 120 (provided prices do not change), to a new level of Comparison of the two questions shows that the introduction of a variable tax lowers the multiplier. 4. An increase in autonomous spending, whether it be consumption, investment or government spending, increases GDP in the initial round by exactly the amount of the increase in spending: there is no difference between C, I and G in this respect. A tax reduction, however, does not initially increase GDP, but only disposable income. The initial increase in GDP is less than this; it is equal to the reduction in taxes (increase in disposable income) times the marginal propensity to consume. Note also the minus sign: GDP moves in the opposite direction from the tax change. 5. At each level of GDP, G rises by 120, while C falls by three quarters of 120, or 90. Therefore there is a net increase in expenditures of 30, as follows:

3 Equilibrium GDP has risen by 120, to (This is an example of what is sometimes called the balanced budget multiplier. When government spending and autonomous taxes are raised by the same amount, in this case GDP rises by that amount.) 6. To reduce aggregate demand, the government can reduce its spending on goods and services, raise taxes or reduce transfer payments. To increase aggregate demand, it can do the opposite: increase government spending, reduce taxes or increase transfer payments. 7. Since you want to reduce GDP by 120, and since the multiplier is 4, you must take some action that will have an initial impact of reducing expenditure on GDP by 30. You may cut government spending by 30. Instead, you may raise taxes or reduce transfer payments by 40. Either of these latter two policies will lower disposable income by 40 and, since the marginal propensity to consume is 0.75, lower consumption by In this case you want to increase GDP by 120, from 1720 to Because the marginal propensity to consume is 0.75, and the marginal tax rate is 1/3, the multiplier is 2. Therefore, you must take some action that will have the initial effect of raising expenditure by 60. You may raise government spending on GDP by 60, or you may lower taxes or raise transfer payments by Answers will vary. Good answers will consider the likely effectiveness of the policy in increasing aggregate supply, plus other effects such as the impact of the policy on income distribution and the budget deficit. 10. A capital gains tax cut will increase aggregate supply only insofar as it persuades people to increase their capital investments. Whether or not this happens, the tax cuts will lead to an increase in aggregate demand and a reduction in tax revenue. a. A tax cut on the gains from all investments will result in the largest loss in tax revenue and the largest increase in aggregate demand. In terms of its effects on investment, it will influence only new investment, not investments already made. b. If the tax cut is applied only to gains on investments made since the tax cut, the revenue loss and impact on aggregate demand will be less than in part (a). The impact on aggregate supply should be exactly the same as in (a), since only new investments can be affected by a change in policy. c. A tax cut only on certain strategic types of investments would have the least effect of the three policies on tax revenue and aggregate demand. It would probably have a somewhat smaller effect on aggregate supply, but not much smaller if the tax cuts are carefully targeted. If the goal is to increase aggregate supply, without having too much effect on aggregate demand, in order to increase production while at the same time easing inflationary pressures, then policy (c) is the most desirable. Answers to Appendix Questions 1. Y = C + I + G + (X - IM) C = DI DI = Y - ( Y) DI = 0.75Y C = (0.75Y - 200) C = Y C = 0.6Y - 40 Y = 0.6Y Y = 0.6Y + 680

4 0.4Y= 680 Y = (1/0.4) 680 Y = = 1700 Equilibrium GDP is There are different ways to find the multipliers, any one of which is correct. For government purchases: (i) Note that equilibrium GDP is 2.5 times all autonomous spending. Since G is autonomous spending, the multiplier for G is 2.5. (ii) Raise G from 480 to 481. Working through the algebra, this comes to 0.4Y = 681, Y = So the increase in G of 1 has raised Y by 2.5, and the multiplier is 2.5. (iii) From the formula in the Appendix, the multiplier is: 1/1 - b(1 - t) = 1/[1-0.8(1-0.25)] = 1/[1-0.8(0.75)] = 1/(1-0.6) = 1/0.4 = 2.5 For fixed taxes: (i) (ii) (iii) Note that a reduction in fixed taxes increases GDP (so the sign of the multiplier is negative) and that it increases spending in the first round by the marginal propensity to consume times the tax reduction. So the tax multiplier is the multiplier found above, multiplied by (minus) the MPC, or 2.5 (-0.8) = -2. Raise fixed taxes in the model from 200 to 201. Working through the algebra, this comes to 0.4Y = 679.2, Y = So an increase in taxes of 1 has reduced GDP by 2, and the multiplier is -2. From the formula in the appendix, the tax multiplier is -b/1 - b(1 - t) = -0.8/[1-0.8(1-0.25)] = -0.8/[1-0.8(0.75)] = -0.8/(1-0.6) = -0.8/0.4 = -2 To raise GDP by 100, (a) raise G by 40, and the multiplier of 2.5 will do the rest, or (b) lower taxes or raise transfer payments by 50, and the multiplier of -2 will do the rest. 2. There are different ways to answer this problem. (a) If you have already answered Question 1, note that the government wishes to raise GDP by 100, and that the multiplier for G is 2.5. Therefore the increase in G that is needed is 100/2.5 = 40, and so G should be 520. (b) The problem can be solved from the beginning. Again, Y = C + I + G + (X - IM), but in this case, Y is known to be 1800, while G is unknown. C = DI DI = Y - ( Y) DI = 0.75Y C = (0.75Y - 200) C = Y C = 0.6Y = 0.6(1800) G - 80; 1800 = G - 80 G = 520.

5 3. (a) Y = C + I + G + (X - IM) C = 0.9(Y - T) C = 0.9[Y - (1/3)Y] C= 0.9[(2/3)Y] C= 0.6Y Y = 0.6Y Y = 0.6Y Y= 600 Y = (1/0.4) 600 Y = = 1500 Budget deficit = G - T = [(1/3) 1500] = = 40 (b) G falls by 40, to 500. With a multiplier of 2.5, Y falls by 100, to Taxes, which are one-third of GDP, fall by 33 to 467. So at the new equilibrium GDP, the deficit has fallen from 40 to 33 ( ), but it has not disappeared. Although G fell by the amount of the deficit, this in turn caused Y to fall, which in turn lowered taxes, and the deficit persisted. 4. In this problem, set G = T = (1/3)Y. Then: Y = C + I + (1/3)Y + (X - IM) C= 0.9DI DI = Y - (1/3)Y DI = (2/3)Y C= 0.9(2/3)Y C= 0.6Y Y = 0.6Y (1/3)Y - 40 Y - 0.6Y - (1/3)Y = Y( ) = Y= 60 Y= (1/0.067)60 Y= (15)60 Y= 900 So, if government spending is cut until G = T, then equilibrium GDP will be 900, and G and T will both be one-third of this, or 300.