FISKAL POLICY

Fiskal policy is

• Fiskal policy is the setting of the federal budget and thus comparises decisions on goverment spending and taxation.

• In the consideration of the classical view of fiscal policy, it is conveniet to begin with government spending

Government spending

• Like a business or household, the government has a budget constraint, a condition that states that all expenditures must be financed from some source, the goverment has three sources : taxation, selling bonds to public, or creating money

• To increase spending, then the goverment must incrase taxation,

sell additional bonds to the public, or increase the money supply,

for now, to avoid bringing in a monetary policy change, we

assume the money supply to be fix, we also assume that tax

colections are fixed, the incrased government expenditures are

therefore assumed to financed by selling bonds to the public

• The effect in the leonable funds market of an incrase in

goverment spending financed by a sale of bonds to the public is

show in figure 4.5

Interest rate

• r s

∆g

r1

r2 B A

• i + ∆g• • i

• s,i, g – t i1 i0 = s0 s1

Loanable funds

TAX POLICY

1. Demand – side effects

As long as we consider only the possible effects on aggregate

demand, analysis of a change in taxes produces results that

are analogous to those for government spending. For

example by increase the disposable income of household, a

tax cut might stimulate consumption demand. If however the

government sold bonds to the public to replace the revenues

lost by the tax cut

• If revenue lost because of tax cut are replace

by printing new money, then, as with an

increase in government spending, the money

creation will increase aggregate demand and

the tax cut will cause the price level to rise

2. Supply – side effects

If the tax were simply a lump sum cut, meaning, for

example, that every household received a tax cut of

$100, then the demand – side effects would be all

that we would need to consider. But suppose the tax

cut was in the form of a reduction in income tax

rates. Suppose the marginal income tax rate were

cut from an initial rate of 40 percent to a new rate of

20 percent.

• Instead of having 40 cents of every additional

dolar taken as a tax payment, only 20 cents

would now be taken. In the classical model

such a change would have an incentive effect

on labor supply. The change would effect the

supply side of the model and would effect

output and employment

Labor market equilibriumwp N (ty = 0,40 )

N (ty = 0,20 )

Nd

N N0 N1

Output determined along the production function

y

F ( K , N ) Y1

Y0

N0 N1

Aggregat supply and demand p ys (ty = 0,20 ) ys (ty = 0,20 )

p0

p1

yd

y y0 y1