Question

4. Answer the following question on the impact of economic policy.

1. To answer this question, assume you are a Keynesian economist. What will happen to the real output of the economy if the government decides to raise income taxes? Explain why Keynesians make this argument. (Hint: Focus on Short Run Aggregate Demand/Aggregate Supply analysis but answer with words not a graph.)

2. Student A argues that the government has just implemented a contractionary monetary policy because increasing taxes sucks money out of the economy. Is student A correct? Why or why not?

3. Student B argues that raising taxes will have no effect on the output levels of the economy because the economy always operates at full employment. Is Student B using classical macroeconomic analysis or Keynesian macroeconomic analysis? If Student B is correct, what would happen to the price level if the government introduced a tax increase? Explain why.

Answer 1

A1. In Keynesian macroeconomics, if the government decides to increase income taxs, the aggregate demand will decline.

AD=C+I+G+NX

where AD- aggregate demand,

C- goods demanded for consumption,

I- goods demanded for investment,

G- goods demanded by government, and

NX- net exports

A rise in the incomes taxes will lead to a decline in the purchasing power of people which will reduce the consumption (C). As a result, aggregate demand (AD) will fall, leading to a fall in the real output.

A2. Student A is wrong. Raising income taxes is a contractionary fiscal policy. Under fiscal policy, the government attempts to influence the economic growth by changing government spending or taxes.  

With the rise in income tax rates, the governement has left a lesser amount of disposable income with people which will induce them to purchase lesser amount of goods, thus reducing the total aggregate demand as well as real output. The contractionary fiscal policy does not suck money out of the economy. Instead, the government take this measure to slow down the pace of economic growth while keeping a check on inflation in the economy.  

A3. Student B argues that increase in taxes will have no impact on the output leves of the economy because the economy is always at full employment level. When he makes this statement, student B is using classical macroeconomic analysis.

The major assumption of the classical macroeconomic analysis is that the economy is always at full employment level, that is, there is no involuntary unemployment in the economy (except for frictional unemployment). As such, in the classical model, the aggregate supply curve (AS) is perfectly inelastic at the full employment level, no matter what aggregate spending may be.

Now, increase in taxes by the government will reduce the amount of money hold by people with which they can purchase commodities. As a result, the aggregate demand will decline. This decline in the aggregate demand means that the economy is producing at below the full employment level. Since classical economists believe that the economy will always remain at the full employment level, this reduction in output will eventually increase towards the full employment level which, in turn, will reduce the price level.