Question

Address the following:
The text describes several fiscal policy options to stabilize the economy: Changes in Government Purchases, Business Taxes, Income Taxes, and Transfer Payments. Based on what you’ve learned so far in the course, determine if Italy currently needs economic stimulus or contraction. Describe how each policy option could specifically be used to change the national economy. Example: Country Z needs economic stimulus. The government could lower the business tax on buying new equipment. This would stimulate the economy because firms would have more money to invest which, in turn, increases demand in the equipment supply sector.

Answer 1

Introduction

Italy has been one country which has always gained from footfall of tourists among other major industries which the country has. The Corona Virus Pandemic has undoubtedly hit the world economy very bad with aggregate demand going down way more than it could have been anticipated by any economist at the start of the pandemic.

The resultant is reduced demand for goods and services, as people are prohibited from going outside and themselves are taking precautions. International travel is banned which gives the country another major shock as a large part of its overall income comes from the tourism industry. As this happens, producers of goods and services cut down on their production levels and fire people to curtail their cost of operations. The end result of this is that a recession cycle has taken place in the economy.

Now, when we know that all of these variables has hit the economy hard, and the flow of money in circulation is low, the end result is that most economies across the globe are following a monetary policy expansion, whereby they are wanting to increase the flow and normalize the economy as far as possible.

It is therefore, recommended for the country to use expansionary policies in terms of its fiscal measure to help increase the flow of money and ensure that the economy can return back to its normal path over a period of time.

Case Specifics: -

Detailed explanation of the listed techniques along with their net effect is as explained: -

1) Changes in Government Purchases: -

As the country is going through a recession phase, increasing government purchases during this period would mean, that the government would provide contracts to numerous private industries for tasks such as infrastructural development, roadways and other public projects. On one hand, they would help in strengthening the economy in its development path, and on the other hand, it would help in increasing the flow of money in the economy. Both these aspects will ensure that recovery can take place and the expansionary policy is helpful in increasing aggregate demand and supply. As additional money flowing would mean additional jobs for people who will work in firms that the government procures from which will help in correcting the recession by increasing income levels

2) Business and Income Taxes: -

Both Business Owners as well as individuals pay taxes to the government, when they earn money in the country. Businessmen provide the government taxes from the profits which they earn post deductions whereas income tax is paid by people who earn from salaries or are self-employed.

As part of the expansionary policy, the government of Italy must reduce the rate of business as well as income tax. This creates a situation wherein the net disposable or available for purchase income of people increases in the country. It becomes easier for them to be able to demand for goods and services and in turn businessmen also feel easier to expand operations.

For example, if a consumer earns 100$ a month, 10% of which goes to the government, his net income post deductions is 90$ which can be spent on consuming goods and services. Now if this income tax rate is changed to 5%. he would then be able to purchase goods from 95$ worth of currency. The remaining will go towards taxes. Same is the case with producers who will then have additional capacity to pay to their workforce and expand operations if business taxes are reduced.

3) Transfer Payments: -

Developed countries like the United States have already used transfer payments as a technique, whereby they have provided money to the needy people directly to the tune of 1200$. Again, the net effect of such a thing is that the income of people directly increases and is a way of fiscal stimulus and expansion. These represent payments which are made by the government without expecting any returns whatsoever. They are usually provided to the marginal groups and should be used by Italy as a tool to expand and have enough demand for goods and services in the country.

Net Effects: -

Now, that we know that the government should initiate an economic fiscal expansion strategy, the details of which have been described above, we look at the net benefit which the country would receive as a result of this expansion in terms of the aggregate demand and supply.

This can be explained as follows: -

In the graph above, we see that the price rises from P1 to P2 and the Quantity Demanded rises from Q1 to Q2 this can also be interpreted as the GDP. The aggregate demand rises from Initial Demand to Increased Demand and the Equilibrium shifts from E1 to E2 respectively. This is a transition which takes place in an expanding economy and can be expected in Italy if the government takes the required steps as indicated above. We can also see a change in supply along the edge between E1 to E2 as the price rises from P1 to P2 and equity from E1 to E2 respectively.

Please feel free to ask your doubts in the comments section if any.