Discuss how the government can use discretionary fiscal policy and automatic stabilisers to stabilise fluctuations in real GDP. What tools does the government have at its discretion to stabilise the economy? Suppose the government decides to decrease income taxes. Show in a diagram and explain how this policy will lead to an increase in real GDP. Explain how potential output may be affected.
Any government program that tends to reduce fluctuations in GDP automatically is called an automatic stabilizer. The reduction in economic activity automatically reduced tax payments, reducing the impact of the downturn on disposable personal income. Furthermore, the reduction in incomes increased transfer payment spending, boosting disposable personal income further. Fiscal policy is the use of government expenditures and taxes to influence the level of economic activity; it is the government counterpart to monetary policy. Fiscal policy is the best counter-stabilisation tool available to any government. Discretionary government spending and tax policies can be used to shift aggregate demand. Expansionary fiscal policy might consist of an increase in government purchases or transfer payments, a reduction in taxes, or a combination of these tools to shift the aggregate demand curve to the right. A contractionary fiscal policy might involve a reduction in government purchases or transfer payments, an increase in taxes, or a mix of all three to shift the aggregate demand curve to the left. Income taxes affect the consumption component of aggregate demand. 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. That shifts the aggregate demand curve rightward by an amount equal to the initial change in consumption that the change in income taxes produces times the multiplier. 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, the equilibrium level of real GDP rises to $12,260 billion, and the price level rises to P2.
$12,000 $ 12,260 $12,360
The economy shown here is initially in equilibrium at a real GDP of $12,000 billion and a price level of P1. A reduce of $200 billion in the level of Income Taxes (ΔT) shifts the aggregate demand curve to the right by $360 billion to AD2. The equilibrium level of real GDP rises to $12,260 billion, while the price level rises to P2.