Question

Discuss how the potency of fiscal policy to influence aggregate demand (of the current year) depends on whether there are households that currently face borrowing constraint or not for the following cases. 1) (7 points) The government reduces the current personal income-tax and it is supposed to be temporary. 2) (8 points) The government announces that there will be a temporary reduction in the personal incometax in the next year.

Answer 1

● INTRODUCTION:

Their effect on demand in the first place. Tax cuts increase demand by rising disposable incomes and fostering more entrepreneurship. Tax hikes do the same. Such impacts on demand can be important when the economy is weak but smaller when it operates close to capacity. Economic activity reflects an equilibrium between what people, companies and governments want and what they want to sell. Economic policy has a bigger impact on demand in the short term – with an emphasis on the next one to two years .. For example , when the economy is poor, by lowering interest rates or buying financial security, the Federal reserve attempts to improve consumer and business demand. Congress, however, will raise demand through higher expenditure and lower taxes.
By rising the wages of the workforce at home, tax cuts boost domestic demand. By. the after-tax cash flow of companies that can be used to pay dividends and grow business, tax cuts can improve business demand, and by making hiring and investing more attractive

CASE 1: Lower rates of income tax raise consumer purchasing power and may improve aggregate consumption, triggering higher economic growth (and inflation possibly). On the supply side, decreases in income taxes will also increase labour incentives – resulting in improved productivity.The effect of tax cuts depends, however, on how the tax cuts are funded, whether the state of the economy and low tax rates ultimately boost efficiency and readiness to work.The Influence of Income Tax Reduction Expenditure rose. Their discretionary income will be raised. They can retain more of their gross income with lower income tax rates so they can easily invest more money. More growth in the economy. We might expect consumer expenditure to increase with lower tax rates because employees are better off. Consumer expendi- tion could contribute to an increase in consumer spending that will result in higher economic growth attributable to a portion of aggregate demand ( AD) (approximately 60 percent).

CASE 2:

We must stress that the use of government expenditures and monetary policies to change the economy is fiscal policy. Expansionary fiscal policy increases the overall demand levels either by raising government expenditure or through tax reductions. The policy is not based on all expenditure (e.g. increased spending accompanying a war). When the economy is in recession and produces below its potential GDP, expansionary fiscal policy is most fitting. Contractional fiscal policy reduces aggregate demand either through increases in state expenditure or by higher taxes. When an economy generates more than its potential GDP, contractionary fiscal policies are most suitable.