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 income- tax in the next year.

Answer 1

Fiscal policy, refers to the policy under which  the central government earns money through taxation and how it spends money. In respect to the economy, a government will cut tax rates while increasing its own spending; It will raise taxes and cut back on spending. Fiscal policy affects aggregate demand through changes in government spending and taxation. Those factors influence employment and household income, which then impact consumer spending and investment.

1.) In CaseThe government reduces the current personal income-tax and it is supposed to be temporary.

• The impact on demand, Reduction in Tax boost demand by increasing disposable income and by encouraging businesses to hire and invest more. Tax increases do the reverse. These demand effects can be substantial when the economy is weak but smaller when it is operating near capacity.
• reduction in Tax increase the household demand by increasing workers’ take-home pay. reduction in tax can boost business demand by increasing firms’ after-tax cash flow, which can be used to pay dividends and expand activity, and by making hiring and investing more attractive.