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Demand-Side Policy: Demand-Side Policy: Greater Spending Greater Spending Means Higher PricesMeans Higher Prices

Real GDP

Pri

ce

Le

ve

l

(c) Aggregate Demand and Supply in the classical range of AS curve. (Prices rise without significant improvements in output and employment.)

AD1

AD

Y?

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Analysis of a Analysis of a Tax-and-Spend Tax-and-Spend PolicyPolicy

Government increases spending, but finances it with tax increases. The increase in spending shifts AD to the right, but the increase in taxes reduces the incentive to work(???), shifting AS to the left.

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Crowding OutCrowding Out

Government Deficit Borrowing by Government

Government Demand for Credit Interest Rates UP.

Higher interest rates Investment Spending DOWN

Private investment is “crowded out” by debt-financed public (gov’t) spending.

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Other impacts of Other impacts of Budget Deficits and National DebtBudget Deficits and National Debt

Crowding out of private investment Future capital stock DOWN Future Output DOWN .

Interest rates UP Currency Appreciation Foreign Goods Cheaper Imports UP Net Exports DOWN GDP DOWN

National Debt UP Interest paid by government UP.

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U.S. Government U.S. Government Revenues and Revenues and ExpendituresExpenditures

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U.S. Government Expenditures U.S. Government Expenditures as a Percentage of GDPas a Percentage of GDP

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Fiscal Policy: Some Definitions

Demand-side policies: spending and tax policies designed to stimulate or slow aggregate demand.

Supply-side policies: policies designed to increase productivity and enterprise.

Discretionary Fiscal Policy: changes in government spending and/or taxation aimed at achieving a policy goal.

Automatic Stabilizer: an element of fiscal policy that changes automatically as income changes.

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Automatic StabilizersAutomatic Stabilizers

Progressive Taxes– As income falls, the tax rate also falls,

helping to maintain buying power and hence aggregate demand

Transfer Payments – Examples: Unemployment insurance,

welfare, subsidies– Insure that buying power is not reduced at

the same rate as income

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Taxes: Some Definitions

Direct taxes: on individuals and firms. Examples: income taxes and value-added

taxes (VAT). Indirect taxes: on goods and servicesTax rate structures:

– progressive tax: rate increases with higher income.

– regressive tax: rate falls with higher income.– proportional tax: rate is constant.

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Central Government Spending by Central Government Spending by Functional CategoryFunctional Category

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Supply-Side Economics and the Laffer Curve

•Taxes are a disincentive to productive activity.

•At marginal tax rates greater than t, the tax base shrinks at a faster rate than the increases in marginal tax rate.

•Net result: increases in marginal tax rates beyond t result in reduced tax revenues.

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