Question

Essay Question. Since the new administration has taken office, the following macro policies have been implemented by Congress and the Federal Reserve:

Income taxes on individuals have been lowered

Corporate taxes have been lowered

The Federal Reserve has raised interest rates

The government has significantly increased spending, much on the military

Using your knowledge of the IS-LM-BOP model and/or other ideas in macroeconomics, analyze what you think the future holds for the US economy. Explain the net effect on major economic indicators in the US. (Use IS-LM-BOP graphs).

Answer 1

When the Congress and the Federal Reserve have undertaken the monetary policy of increasing interest rates and fiscal policies of increasing decreasing personal income and corporate taxes and increased government spending, especially military spending, there will be certain effects on the economy.

1. Lowering of Personal Income Taxes and Corporate Taxes- With lowering of personal income taxes, there is now more disposable income to spend in the hands of individuals. This will lead to an increase in demand for goods and services and consumption expenditure. This will, in turn, lead to increase in production of goods and services. A lowering of corporate taxes means that the businesses can now invest more in the expansion. This will lead to an increase in labor and other corporate spending. An increase in demand for labor and corporate spending leads to an increase in employment, thereby increasing demand for goods and services.

So, lowering taxes boosts consumption and investment, employment, increase in demand for goods and services.

In terms of the IS-LM curve, there will be a shift of the IS curve outwards to the right, which corresponds to increase in income.

As we see from the graph above, our initial IS-LM curves are IS and LM. With equilibrium at 'a', income level at 'Y' and interest rate at 'i'.

With a lowering of taxes and increase consumption and investment expenditure, there is a shift of the IS curve outwards to the right to IS₁. We have a new equilibrium point at 'b', which corresponds to a higher level of income at 'Y₁'.

2. Increase in Interest Rates - As we saw above in the graph, with the outward, right-hand shift of the IS curve, the new equilibrium provides us with an increase in output but it also leads to an increase in interest rate. With an increase in consumption and investment expenditure, there will ultimately be an increasing demand for money, which will outstrip the increase in the supply of money that lowering of taxes offered. This will lead to an increase in interest rates, as we see from the graph above.

When IS shifts out to IS₁, at the new equilibrium point 'b', we move up the LM curve to the new interest rate of 'i₁', corresponding to the equilibrium point 'b'. That is exactly what the monetary policy of the reserve will be - to counter the increase in demand for money. To avoid inflationary pressures, the Fed will increase the interest rate to 'i₁'.

3. Increase in government military spending - When the government increases its spending on economic infrastructures like roads, transports, hospital and other public utilities including defense, there will be an increase in consumption and therefore income. In the case of defense spending, we expect the same. From those that service the defenses, there will be an increase in demand for goods and services.

There will be a shift out of the IS curve outwards and to the right, with increases in income, again represented by the graph above. However, this will lead to an increase in interest rates by the Fed, as we saw in point 2.

One point to keep in mind is that in spite of Keynesian theory of increase in the budget deficit to boost the economy and that in the long-run the increase in growth, productivity, and output of such a boost with reducing the deficit, this is not so befitting the military spending. The growth in productivity and output of spending in defense will be limited in its positive impact than what we can expect from spending in other utilities. The reason being, even though, the military is for the ultimate benefit of the people of the country, the multiplier effect of military investment is much lower than the multiplier effect of investment in other public utilities, whose benefit the economy and people can immediately feel - increase in schools, hospitals, transport, communication, welfare system, disability support, other medical benefits etc.

Increase in defense spending has a negative impact on the budget deficit, the reason being the growth in consumption and investment expenditure as boosted by defense spending will not be high enough to counter the negative impact of the budget deficit.

Over the last 2 decades, there has been an average, annual increase of U.S defense budget by 3%. Defense spending comprises approximately 16% of the US budget. For the fiscal year 2019, the US fiscal deficit is expected to be $985 billion.