Question

1. Briefly describe how income taxes affect the size of the aggregate demand multiplier.

2. List two fiscal policy actions a government should take to eliminate a recessionary (deflationary) gap.

3. What is crowding out and how does it affect the potential impact of fiscal policy?

4. Make an economic argument (just one) on why a proposal to lower payroll taxes is a good thing or a bad thing. (The point here is to have you make an economic argument, not whether you think the policy proposal is good or bad.)

Answer 1

1. THE LEVEL OF INCOME TAXES INVERSELY AFFECT AGGEGATE DEMND MULTIPLIER.

LET US TAKE TAX MULTIPIER.

CHANGE IN OUTPUT / CHANGE IN INCOME TAX (LUMPSUM) = - mpc/ - mpc

AS THE LEVEL OF INCOME TAX RISES, THE LEVEL OF DISPOSABLE INCOME FALLS, THE CONSUMPTION LEVEL DECREASES. THIS LEADS TO FALL IN AGGREGATE DEMAND VIA MARGINAL PROPENSITY TO CONSUME. THEREBY THE RELATIONSHIP IS INVERSE.

2. TWO FISCAL INSTRUMENTS : FALL IN TAX RATE AND HIKE IN PUBLIC EXPENDITURE. BOTH OF THESE INSTRUMENTS ARE COMPONENTS OF EXPANSIONARY FISCAL POLICY. THE WILL GENERATE DEMAND AND BOOST UP THE ECONOMIC POTENTIALS.

3. THE DECLINE IN PRIVATE INVESTMENT DUE TO THE HIKE IN THE COST OF BORROWING AS A CONSEQUENCE OF EXPANSIONARY FISCAL POLICY IS CALLED CROWDING OUT EFFECT.

IF THE FISCAL OLICY IS EXPANSIONARY THEN THE EXCESS DEMAND IN THE LONABLE FUNDS MARKET WILL PULL UP THE INTEREST RATE AND THIS WILL REDUCE THE WILLINGNESS TO INVEST. THE PRIVATE INVESTORS WILL BE CROWDED OUT.

4. LOWERING PAY ROLL TAX WILL BE AN EFFECTIVE ECONOMIC RELIEF PACKAGE DURING ACUTE DEMAND CRISIS. THIS WILL PUT IN MORE MONEY IN THE POCKETS OF NEEDY . THIS WILL INJECT MORE LIQUIDITY IN THE ECONOMY AND WILL BE INSTRUMENTAL IN BOOSTING DEMAND POTENTIALS.