Government and Fiscal Policy

Read this chapter to learn about how the government's fiscal actions influence aggregate demand. The chapter first introduces the components of the government's budget and then discusses discretionary fiscal policy and automatic stabilizers used to influence the economy. Some lags in the implementation of fiscal policy are identified and the concept of crowding out is introduced. Attempt the "Try It" exercises at the end of the section.

2. The Use of Fiscal Policy to Stabilize the Economy

Changes in Income Taxes

Income taxes affect the consumption component of aggregate demand. An increase in income taxes reduces disposable personal income and thus reduces consumption (but by less than the change in disposable personal income). That shifts the aggregate demand curve leftward by an amount equal to the initial change in consumption that the change in income taxes produces times the multiplier. A change in tax rates will change the value of the multiplier. The reason is explained in another chapter. A reduction in income taxes increases disposable personal income, increases consumption (but by less than the change in disposable personal income), and increases aggregate demand.

Suppose, for example, that income taxes are reduced by $200 billion. Only some of the increase in disposable personal income will be used for consumption and the rest will be saved. Suppose the initial increase in consumption is $180 billion. Then the shift in the aggregate demand curve will be a multiple of $180 billion; if the multiplier is 2, aggregate demand will shift to the right by $360 billion. Thus, as compared to the $200-billion increase in government purchases that we saw in Figure 12.9 "An Increase in Government Purchases", the shift in the aggregate demand curve due to an income tax cut is somewhat less, as is the effect on real GDP and the price level.