Author: John Bouman

How a Change in Taxes Affects GDP If an increase in government spending leads to an increase in total spending and GDP, then an increase in taxes must lead to a decrease in total spending and GDP, and vice versa. When the government raises taxes, private spending decreases. Keynes noted, however, that the decrease in overall spending from a tax increase is not as large as the increase in overall spending from the same amount of a government spending increase. The reason for this is that people save a portion of their additional income (tax refund) whereas the government spends all of its money. The example in the next paragraph illustrates this. The Tax Multiplier Let’s say that taxes increase by $1,000. Therefore, people’s after-tax income (income available for consumption or savings) decreases by $1,000. If the MPC is 80%, then people would have only consumed $800 of this $1,000. Therefore, total spending throughout the economy decreases by 5 (the multiplier) times $800 = $4,000. This $4,000 is 4 times the change in taxes. Mathematically, we can prove that the tax multiplier is the negative of the spending multiplier minus 1. In the above example, the regular spending multiplier from the previous section is 5 and, therefore, the tax multiplier is -4. Thus, The tax multiplier = – (the regular multiplier – 1) In the above example: The tax...

Demand Side Economics Keynes’s model is a “demand-side” model. Keynes believes that as long as there is enough demand, production (supply) will be sufficient and full employment will result. In order to increase demand, the government needs to increase its spending, according to Keynes. To pay for the additional spending, the government can do one or more of the following: Print more money Incur a deficit (borrow by issuing government securities) Increase taxes The Effect of Printing More Money One of the ways a government can obtain more money for additional government spending is to print more money. The Federal Reserve supplies additional money to the public primarily through Open Market Operations; this is discussed in Unit 9. Printing more money is inflationary. It may be true that initially some people feel wealthier because they are the recipients of the additional government money. These people can increase their spending relative to what it was before. Increasing the money supply (printing money) also lowers interest rates in the short run. This stimulates the economy in the short run because lower interest rates leads to more borrowing and more spending. However, as soon as inflation takes effect, interest rates rise and people will be harmed by rising prices. In the long run (after the inflation takes effect, and subsequently, interest rates rise), the decrease in purchasing power and the accompanying decrease...

The Aggregate Demand Curve In Unit 2, we learned that a demand curve illustrates the relationship between quantity demanded and the price of one product. In this unit, we discuss Aggregate demand. Aggregate demand represents the quantity demanded of all products in a certain country or area at different price levels. The aggregate demand curve is downward sloping, just like one product’s demand curve. It slopes downward because of the substitution effect and because of the income effect. The substitution effect states that as the price of a product decreases, it becomes cheaper than competing products, ceteris paribus, and consumers will substitute the cheaper product for the more-expensive product, and vice versa. In the case of the aggregate demand curve, we consider all domestic products, so the substitution effect only applies to the substitution of domestic products for foreign products. In other words, when domestic products become cheaper, buyers purchase more of these products and they purchase fewer of the relatively more-expensive foreign products. If we were to consider a “world demand” curve, the substitution effect would not apply (until we start production on other planets!). The income effect states that as the price of a product decreases, buyers will have more income available to purchase more products, and vice versa. In the case of the aggregate demand curve, if the average price level of all products decreases, buyers...

What’s in This Chapter? Governments conduct two types of policies to affect the economy: fiscal policy and monetary policy. In democratic countries fiscal policy is decided by elected politicians. In most countries monetary policy is decided by the country’s central bank. The nation’s fiscal policy in the United States is in the hands of the President and Congress. It is the subject of this unit’s discussion. Monetary policy, the other main economic policy affecting the economy, conducted by the Federal Reserve System in the United States and central banks around the world, will be discussed in detail in Unit 9. On a national scale, in the United States, Congress and the White House decide how much money to spend on the various government programs. They also decide how much to tax people, and if and how much money to borrow. The fifty states, Washington, D.C., and the various counties and municipalities have their own expenses and sources of revenue. Government spending and taxation policies have an important effect on the nation’s employment, incomes, economic productivity, and economic growth. This unit also discusses fiscal policy philosophy according to Keynesian and classical economists....

Definition of Fiscal Policy If a government spends more than it receives in tax revenue, it runs a budget deficit and it can print more money (monetary policy, covered in unit 9) or borrow money (fiscal policy, covered in this unit). Fiscal policy is a government’s attempt to affect economic activity by changing government expenditures, taxation, borrowing, and lending policies. A government can choose to change spending on highways, defense, education, public works, and social programs. A government can change tax rates, tax systems, and taxation to certain groups. Keynesian Economics and Fiscal Policy Keynes supported both active fiscal and monetary policies, but believed that fiscal policy is more effective. According to Keynes, governments should primarily increase spending when the economy experiences a recession. He stated that governments can also lower taxes to stimulate the economy, but he preferred increases in government spending because governments spend all of their money whereas citizens may save part of their tax cuts. Conversely, governments should decrease spending and/or raise taxes when the economy experiences inflation during full employment. Many politicians, influenced by Keynes’s encouragement to run deficits to stimulate the economy, support active fiscal policy. Since Keynesian economics first became popular in the 1930s, government spending has increased significantly. Politicians often cater to special interest groups, because it translates into more votes and increased campaign donations. Consequently, government spending often increases even...