Fiscal Policy effectiveness

When an economy has just come out of a recession a persistent budget deficit exists to in order to stimulate the economy. However, the existence of this large deficit in the long run can evolve into a problem due to the financing of the debt, and the large opportunity cost it holds. For these reasons a government would want to reduce this. Blanchard & Johnson (2013) outline the two dominant fiscal tools that accomplish a reduction in the government deficit in the short run: increasing taxes and decreasing government spending. Such manipulation of fiscal policy is called fiscal consolidation. In conjunction with this question, the behavioral equations dictate that the endogenous variables in this closed economy are consumption, disposable income and investment. This essay will analyse and evaluate the effects of each fiscal tool on all endogenous macroeconomic variables, then justify which fiscal tool is the most beneficial to use. This will be done by analyzing the effects the fiscal tools have on this question’s equilibrium of the goods and financial markets (Fig. 1). See Appendix A for the steps of derivations for the IS/LM relations.

An increase in taxes has direct and indirect effects to the economy. Consumers and firms are directly taxed more through income and corporation tax. For the consumer, this decreases their disposable income that leads to a decrease in consumer demand. For the firms, they experience a decrease in profits consequently leading to a decrease in investment. When indirect taxes increase, higher prices and lower real income is present. Overall this leads to a decreased aggregate demand through the economic intuition; higher taxes cause decreased disposable income that causes consumption to decrease in the economy, consequently decreasing demand then output. Upon looking at the intricate components of the endogenous variables we can see why they decrease, thus decreasing aggregate demand. Disposable income decreases, as the amount of income they have after paying their taxes is less. An increase in tax would have an effect on consumer’s confidence as they are less optimistic about the future and consequently decrease their propensity to consume () as the proportion of the disposable income that individuals desire to spend on consumption, decreases due to a decreased disposable income (). In this climate consumer’s propensity to save for the future is the more dominant factor. In terms of the business sector, firms have a smaller amount of income for investment. As a consequence of all these variables decreasing, output decreases from;

to

The increase in taxes can be shown by T