| 1. In the tax cut example on pages 236–37, |
| ( a ) By how much does consumer saving increase initially? |
| ( b ) How large is the initial spending injection? |
| This was the objective of the 2008 Bush tax cuts, which gave all taxpayers a rebate of |
| $300–600 in the summer of 2008. By putting $168 billion more after-tax income into the |
| hands of co n sumers, Congress hoped to stimulate (shift) the consumption component of |
| aggregate d e mand. President Obama used the tax cut tool as part of his 2009 stimulus package |
| and again in 2011. |
| Taxes and Consumption. A tax cut directly increases the disposable income of consumers. |
| The question here, however, is how a tax cut affects spending. By how much will |
| consumption increase for every dollar of tax cuts? |
| The answer lies in the marginal propensity to consume. Consumers won’t spend every |
| dollar of tax cuts; they’ll save some of the cut and spend the rest. The MPC tells us how the |
| tax cut dollar will be split between saving and spending. If the MPC is 0.75, consumers will |
| spend $0.75 out of every tax cut $1.00. In other words, |
| Initial increase in consumption 5 MPC 3 Tax cut |
| If taxes were cut by $200 billion, the resulting spree would amount to |
| Initial increase in consumption 5 0.75 3 $200 billion |
| 5 $150 billion |
| Hence the effect of a tax cut that increases disposable incomes is to stimulate co nsumer |
| spending. A tax cut therefore shifts the aggregate demand curve to the right. |
| Multiplier Effects. The initial consumption spree induced by a tax cut starts the multiplier |
| process in motion. The new consumer spending creates additional income for producers |
| and workers, who will then use the additional income to increase their own consumption. |
| This will propel us along the multiplier path already depicted in Figure 11.4. The cumulative |
| change in total spending will be |
| Cumulative change |
| in spending 5 Multiplier 3 |
| Initial change |
| in consumption |
| In this case, the cumulative change is |
| Cumulative change |
| in spending 5 |
| 1 |
| 1 2 MPC |
| 3 $150 billion |
| 5 4 3 $150 billion |
| 5 $600 billion |
| Here again we see that the multiplier increases the impact on aggregate demand of a fiscal |
| policy stimulus. There’s an important difference here, though. When we increased gover nment |
| spending by $200 billion, aggregate demand increased by $800 billion. When we cut |
| taxes by $200 billion, however, aggregate demand increases by only $600 billion. Hence a |
| tax cut contains less fiscal stimulus than an increase in government spending of the |
| same size. |
| The lesser stimulative power of tax cuts is explained by consumer saving. Only part of a |
| tax cut gets spent. Consumers save the rest. This is evident in Figure 11.5, which illustrates |
| the successive rounds of the multiplier process. Notice that the tax cut is used to increase |
| both consumption and saving, according to the MPC. Only that part of the tax cut that’s |
| used for consumption enters the circular flow as a spending injection. Hence the initial |
| spending injection is less than the size of the tax cuts. By contrast, every dollar of government |
| pu r chases goes directly into the circular flow. Accordingly, tax cuts are less powerful |
| than go v ernment purchases because the initial spending injection is smaller. |
| This doesn’t mean we can’t close the AD shortfall with a tax cut. It simply means that |
| the desired tax cut must be larger than the required stimulus. It remains true that |
| Desired fiscal stimulus 5 |
| AD shortfall |
| Multiplier |
| The Fiscal Policy Tool |
| CHAPTER 11: FISCAL POLICY 237 |
| But now we’re using a consumption shift as the fiscal stimulus rather than increased go vernment |
| spending. Hence we have to allow for the fact that the initial surge in consumption |
| (the fiscal stimulus) will be less than the tax cut. Specifically, |
| Initial consumption injection 5 MPC 3 Tax cut |
| If we want to use a consumer tax cut to close a GDP gap, we have |
| Desired tax cut 5 |
| Desired fiscal stimulus |
| MPC |
| In the economy in Figure 11.3, we assumed that the desired stimulus is $200 billion and the |
| MPC equals 0.75. Hence the desired tax cut is |
| Desired tax cut 5 |
| $200 billion |
| 0.75 |
| 5 $267 billion |
| By cutting taxes $267 billion, we directly increase disposable income by the same |
| amount. Consumers then increase their rate of spending by $200 billion (0.75 3 $267 bi llion); |
| they save the remaining $67 billion. As the added spending enters the circular flow, |
| it starts the multiplier process, ultimately increasing aggregate demand by $800 billion |
| per year. |
| This comparison of government purchases and tax cuts clearly reveals their respective |
| power. What we’ve demonstrated is that a dollar of tax cuts is less stimulative than a dollar |
| of government purchases. This doesn’t mean that tax cuts are undesirable, just that they |
| need to be larger than the desired injection of spending. The following News shows that the |
| 2008 tax cut boosted consumer spending by 3.5 percent, thereby shifting AD to the right |
| and accelerating real GDP growth. |
AmazingExpert
ecn-360-assignment.xlsx
