Question

Suppose country Zee is a closed economy. Consider AD, SRAS and LRAS for the economy of Zee. Tye economy begins at price level P0, with output equal potential GDP=Y*, budget is balanced.

3.1 Suppose the government of Zee increases tax, T while keeping government expenditure G unchanged. Are we having budget deficit or surplus? What would be the effect of this action on loanable funds, real interest rate, private savings and investment, and levels of debt in country Zee?

3.2 Compare the short-run and the long-run effects of the governments policy stated in 3.1. Briefly mention what dilemma does the government face in implementing this policy.

Answer 1

Increasing tax rates is also called Contractionary Fiscal policy.

Contractionary fiscal policy is a form of fiscal policy that involves increasing taxes, decreasing government expenditures or both in order to fight inflationary pressures. This will lead to a budget surplus. The revenues from the budget surplus are typically used to reduce any existing national debt

Due to an increase in taxes, households have less disposable income to spend. Lower disposal income decreases consumption. An increase in taxes also reduces profits available to businesses and they cut down their investment expenditures. Consumption and private investment are part of the Gross Domestic Product (GDP), which falls as a result. If the government reduces its expenditures and thereby reduces its borrowing, the supply of available funds in the credit market increases, causing the interest rate to fall. Aggregate demand increases as the private sector increase it's investment and interest‐sensitive consumption expenditures. Hence, contractionary fiscal policy leads to a crowding‐in effect on the part of the private sector.

b)This Fiscal policy is a correction mechanism and contractionary fiscal policy is used when the economy is overproducing that is above the natural rate of output and inflation is unusually high. It can happen due to various reasons such as a stock market bubble in which people drastically invested a lot or something like that. Hence long-run impact of this policy is to achieve the natural rate of output and check the inflation from spiraling so that economy doesn't fall into recession.

Elected officials use contractionary fiscal policy much less often than expansionary policy. That's because voters don't like tax increases. They also protest any benefit decreases caused by reduced government spending. As a result, politicians who use contractionary policy are soon voted out of office. This is the dilemma faced by the government implementing this policy.

The unpopularity of contractionary policy results in ever-increasing federal budget deficits. To make up for the deficit, the government just issues new Treasury bills, notes, and bonds.