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Course: Macroeconomics > Unit 3
Lesson 4: Monetary and fiscal policyTax lever of fiscal policy
How government can effect aggregate demand through tax policy. Created by Sal Khan.
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Between2:19and2:30, Sal says that because taxes go down, consumers and firms will have more money, thus spend more money on goods and services thereby increasing GDP. My question is this: Is this an accurate model for rational and irrational actors? I have noticed that quite the opposite is true.(17 votes)
Some research has been done which indicates that, groups of people will respond differently to a decrease in taxes. Some people will start working less instead of spending more for example.
Try googling "substitution effect and income effect in the labor market" for more info.(9 votes)
Correct me if I'm making serious mistakes, please:
With Y = C + I + G + NX (Ex - Im), these are some of the ways to increase GDP:
1) Printing more money (Monetary Policy): interest rates are lowered, individuals and firms have more incentive to borrow money from banks, take on debts in order for investment => I goes up
2) Tax cuts (Fiscal Policy): People and firms get more money put in their hands now => both C and I go up
3) Government borrowing (Fiscal Policy): the government accepts debts in exchange for subsidies or social programs, which encourage production and spending => G goes up
4) Printing more money (Monetary Policy): again, I suppose as the price of OUR money declines, the relative exchange rate of other nations to our country goes down, resulting in our exports being more price competitive while imports being the other way round. Therfore, Net Exports - NX - goes up
If I'm missing something, please let me know right away, will you ?(7 votes)
Yes, those are the theoretical responses to this model. Keep in mind it's just an imaginary model - it doesn't explain the real world, and it doesn't mean any of those things are good ideas to do.(7 votes)
to me it seems that in promising not to raise taxes(to get votes in the election), the current american government is taking on more and more debt to keep the economy running. wouldn't it be wiser to increase taxes on big firms and companies? even with the huge government help they received after the recession, they don't seem to be using the money to hire more people or increase GDP.(5 votes)- The government doesn't take on debt to keep the economy running. The government takes on debt to keep the government running. But yes, raising taxes is more politically difficult than printing money and taking on debt, because voters see the tax money being taken from them. It's much more difficult to see exactly who lost what amount of buying power when the government devalues the currency through printing and borrowing.
So yes, raising taxes would be better than taking on debt, because it distorts the economy less. Ideally taxes would be raised on consumption, so as not to hurt trade balance or send companies overseas (like the high corporate taxes do).(3 votes)
If interest rates are at 2% and inflation is at 3% making real interest rates -1% would it be better to just keep paying off the interest on government debt, and let inflation over time lower the amount we pay off?(3 votes)
Sal said something about selling debt, what would that mean?(2 votes)
If A loans some money to B, but for some reason, before the amount is due, A wants the money back, A can sell the loan to another person C. A keeps the interest that A has already collected, but any further interest that B pays goes to C and when the loan is due, C gets the money back, not A.
In the case mentioned by Sal, private investors will loan money to the federal government. The way they do this is by buying Treasury bonds. These Treasury bonds are basically IOUs from the federal government that can be redeemed on some later date. The Federal Reserve would then buy those Treasury bonds from those investors, and redeem the money itself.(3 votes)
how does lower taxes increase the interest rate? please use an example(1 vote)
Example: Your income was 100$. Tax was 10$. Now taxes are 5$. You have 5$ more at your disposal. This has made you richer. Now your demand for money will rise because you will have more income in form of cash. Why int rates will rise? Think of this in a macro level. Like you there will be tons of people who want money. There's a limited amount of money in the economy. Hence, the higher demand will be satisfied with higher prices (interest rates) just like in any other markets.(1 vote)
- why isn't lower the interest rate specifically mentioned as a monetary policy here?(1 vote)
Lowering interest rates is the goal of expansionary monetary policy, not a tool. The main tool to reach that goal is printing money.(3 votes)
why you are treating the government as it a total liberal state, with no investments?.
while the government can shift the supply to the right by increasing its investments (if it has any!) , thus increasing wages and so on.(1 vote)- Investment is like part of a whole, is can,t change anything in a short period of time, however government can.(1 vote)
- In the monetary video, if Gov't sells debt, the micro supply curve shifts to the left, increasing interest rates. The theoretical effect on the Macro (AD/AS) model is the AD would shift to the left as Investment decreases.
In the fiscal video, Gov't spending increases (by taking on more debt) the AD shifts to the right. Is there a nullifying effect from the debt and thus the decreased money supply?
Thanks, the videos are excellent!
jay(1 vote) - With that additional extra debt the (any) government takes on would that not increase the expenditure on imports as they repay the debt assuming they got the money internationally such as the world bank, IMF or an EU country borrowing from ECB(1 vote)
- If the money was borrowed from an overseas leader then yes the repayments are a flow of funds from the country. Borrowing from overseas tends to push your exchange rate up which hurts exports. However if the capital markets are big enough a country may borrow money from the domestic market, this may however push up the rate of borrowing for domestic consumers. Really a case of damned if you do and damned if you don't; government end up having to choose between the lessor of two evils.(1 vote)
2:19Video transcript
Voiceover: I want to do a quick follow-up to the last video because I did not give a complete picture of all
of the fiscal policy tools that a government has at its disposal. What I focused on in the last video is a government that holds taxes constant, taxes constant, and increases spending. Spending goes up. The only way that a
government could do that is by taking on more debt, or I guess if there are some governments that are saving, saving less, but most of them, they're going to have
to take on more debt. So they're going to take on more debt. Just to think about it in terms of the, in terms of the GDP
expenditure components, we know that GDP, GDP is equal to consumption, which is mostly consumers, individuals, investment, which is mostly firms, and some consumer spending on new houses. Then you have government expenditure, and then you have net exports, which kind of completes the picture. But what we described in the last video is these two things are held constant. Taxes don't change. People, the government isn't
fueling its expenditures with more taxes, so this
part stays constant, but with the extra debt, the government spends
more, so this part goes up, everything else holds roughly constant, and so GDP would go up. The other tool that the government has, has at its disposal, is to hold spending constant, so spending is held constant, and lowering taxes, and lowering taxes, which would essentially put more money in the hands of consumers
of individuals, families, and firms. Once again, the only way they can do that, if you hold spending constant, and you're reducing your revenues, the only way they can
do that is once again, taking on more debt. This is a common theme here. They would have to take on more debt, assuming they don't have any savings to kind of eat up, to
finance this type of thing. Looking at this again, we have GDP is equal to
consumption plus investment plus government spending plus net exports, plus net exports, in this situation, government spending is held constant but because the consumers' and the firms' taxes have gone down, they have more to spend, and they will spend some component of it, and so these two pieces will go up, and GDP will go up. I just wanted to make
sure we added this picture right over here. Fiscal policy isn't just about increasing or decreasing government spending. It can also be about tax policy, increasing or decreasing taxes.