Y = c + g + I + (x-m)
Consumption has been boosted. This will have a knock on effect to levels of Y. The results of such a decrease in taxation can be seen in figure1, which shows the levels of aggregate expenditure. The lowering of taxes will result in the aggregate expenditure curve pivoting upwards from its starting point-AE1 so as to increase the slope of the curve, as shown by AE2. The result of such an increase will be a rise in equilibrium GDP from E0 to E1 because at every level of national income, desired consumption is higher. Such a rise in GDP by putting more money in people’s pockets is a method of fiscal policy chosen by America in order to help minimise the effects of a recession.
Desired expenditure AE=Y AE2- Aggregate expenditure after tax cuts
AE1 –Aggregate expenditure prior to tax cuts
Real national income
By contrast however, Milton Friedman and a monetarist approach would not have implemented such changes in America. Believing that economies were self-correcting, such interference at a government level is not the best method of protecting against the possibility of recession. In his permanent income hypothesis, Friedman argued that people, whatever the rate of taxation and economic conditions, would save money and would spend the same level of personal disposable income every year. For Friedman, consumption was not solely based upon levels of present income but instead relies upon a moving rate of average incomes over the years. As a consequence, a decrease in the direct taxation level would not necessarily have the desired effect- that is to increase consumer spending and confidence through tax cuts, due to saving for the long term. Another alternative to the Keynesian fiscal policy approach is Ando- Modigliani’s life cycle hypothesis. This is based upon the fact that consumption is modelled at an average level throughout a person’s life as they borrow money during early adulthood, spend money and then save for retirement. As a consequence, this life cycle hypothesis suggests that a cut in tax rates will have no effect at all upon consumption expenditure and subsequently, no effect upon overall National income.
It is also possible to assess the impact of a change in the tax rate using the IS-LM curve analysis. The IS curve shows the locus of points that lead to equilibrium in the goods market place. The LM curve shows the locus of points, which generate equilibrium in the money market. A reduction in the tax rate will cause the IS curve to swivel outwards and upwards, as shown in figure x. This will lead to a higher level of GDP and a slight rise the level of interest rates. Although, monetarists would argue that the growth in the rate of interest would crowd out investment levels. Keynesians would argue however that GDP would raise enough in order to overcome the level of interest.
Must complete diagram
A reduction in taxation upon company profits will lead to higher expected future profits. If future expected profit predictions go up, due to a fall in the taxation rate, investment too will go up due to increased confidence in industry. As a result, there will be a rise in aggregate expenditure and subsequently the economy will be boosted.
The second component of fiscal policy lies in government expenditure and investment. In this case, the United States chose to invest heavily in the defence sector, following the tragedy of September 11th and the subsequent war in Afghanistan. Government expenditure is also a component part of aggregate expenditure (AE = C + I + G + X – M). As a consequence, an increased level of government expenditure will boost GDP through investment by not allowing it to ‘dry up’. This is essentially Keynesian theory.
An increase in government expenditure on defence will increase aggregate expenditure, which in turn will cause a rise in equilibrium Real national income, as shown in figure y, from e0 to e1. An increase in expenditure will shift aggregate expenditure upwards, parallel to the starting level. As a result, Real national income will also rise as indicated on the graph below. Aggregate expenditure will shift upwards, parallel to its original position from AE1 to AE2 as government expenditure is given as exogenous. This will produce the multiplier effect. That is, the ratio of the change in GDP to the change in autonomous expenditure that brought it about. In this way, the government of the United States would be budgeting for a deficit; that is, when government expenditure is greater than the levels of revenue obtained through taxation, rather than running a balanced budget. Keynesian economists are inclined to find this non-problematic.
Desired expenditure. Figure….
AE=Y (as Lipsey and Crystal 1999)
AE2
AE 1
Real national income (GDP)
By contrast to this, monetarist theory would discourage governments from spending and investing in business and leaving it to industry themselves to invest. They would encourage this approach because of their belief that government expenditure would lead to a rise in inflation rather than consumption due to a rise in output that will increase prices. In this way, such policy would not cause a sufficient reduction in the output gap.-Should I include a diagram here? The monetarist approach would also argue that the government would be taking a risk by implementing fiscal policies because the multiplier will take time to filter through. Lags that could take place could be policy based, information based, decision based, and execution based. All these lags would mean that the spending programme would take effect at the wrong time or at the wrong place. Consequently, such fiscal policies would be ineffective.
As was possible when considering the effects of a cut in taxation, it is possible to use IS-LM curve analysis to consider the effects that increased government expenditure on defence will have. The IS curve will shift out rightwards. This will cause a rise in GDP but also a rise in the interest rate. This rise in the interest rate would cause investment to fall and become ‘crowded out’. However, it would not fall that much because the rise in the interest rate is only small compared to the rise in GDP. This can be seen in figure….
Complete diagram
GDP
Fiscal policy recommends that governments should lower direct taxation and increase expenditure, in the case of the U.S.A, on defence. In others words the government should protect against a recession by running a budget deficit. It is fair to conclude that monetarist theories, as chosen for use in the constitution of the European bank differ greatly from the Fiscal policies chosen for use by the Bush Administration. It clearly remains to be seen as to whether the tax cuts and increased defence expenditure will produce the required effects in order to minimise the effects of recession in the United States economy.
