How Tax Cut Increases the Level of Aggregate Demand in the Short Run - Assignment Example

Macroeconomic AD-ISLM Analysis a. How tax cut increases the level of AD in the short run. Cut in tax always leads into an increase in the disposable income (Y-T) at every level of income Y. Such an increase in disposable income results into an increase in consumption for every level of income. This makes the IS curve to shift to the right. However, if the money demand is not independent of disposable income, then the LM curve will shift upwards. As such the analysis changes with taxes, it may be altered by making the money demand dependent on the disposable income. A cut on tax is an expansionary policy which leads the aggregate demand to increase and shifting the IS curve to the right (Alquist 2010). In the short run, a tax cut will enable consumers to save (1-MPC) of the cut in tax; the initial increase in spending will be smaller for change in tax than for an equal change in government expenditure. As the IS curve shifts to the right, the effects on interest rate (r) and output (Y) will be smaller for the change in tax than for the change in government expenditure (Alquist 2010). Effects of a monetary expansion An increase in the output results to a shift to the right as more savings will be made when the income is higher. As shown above, since when the demand for goods exceeds the firms the supply, then prices will rise in the market. The shift of LM down to the right is due to the decrease in the tax rate. As the tax reduces, the nominal money supply increases while the nominal interest rate decreases on money resulting to the shift of the AD curve up to the right. In summary, an increase in the nominal money supply in the market, a decline in the interest rate as well as any change that reduces demand for money leads to a downward shift in the LM curve and an upward shift in the AD curve (Alquist 2010). 1b. Income tax allowance increases by UK coalition government following recession. Recent increases in income tax allowance by the UK government have resulted into various economic reactions in the entire sectors in the country. It has been postulated that increases of up to £10,000 have resulted to a total cost amounting to £ 10.75 billion per year. The UK treasury has estimated that the rise in allowance is set to cost an estimated £ 104billion in 2015/16 (Alquist 2010). It is argued that although this money goes directly to the common man who is the taxpayer, there are still more efficient ways that large sum of money can be directed to the person in low income brackets. In the current UK tax system under the coalition government, there are taxable income and nontaxable income. An increase in the personal allowance has occurred more quickly than the rate limit has decreased, tax payers in the higher rate bracket have shared the benefits from the reduced starting rate income tax. The personal allowance tax increase to £10,000 has that the middleclass and upper class households have benefited from the policy change by the coalition government. This is true due to the fact that tax cuts do not favor those who do not earn as well as those who earn little to pay tax. The economic analysis has found that families with more than taxpayer always benefit from tax relief from the increase in personal allowance than those families with one taxpayer. Income tax allowance increases can best be analyzed as in the graph shown below which indicates that the allowance is not progressive when family level is considered. Such an increase makes the disposable income of families to increase thereby encouraging investment as well as demand pull inflation (Alquist 2010). The graph shows the distributional impact of increasing personal allowance to £10,000 in 2012-13. 2 a. Effects of an increase in government expenditure on output, employment and prices in short run. The assumption on the AS curve is that the expected price and the real price are equal in the medium run, but not necessarily in the short run. As such, firms set prices as workers demand wages. In the short run, employers will adjust their future expectations on the price levels. This will make the AS curve to shift upwards. The expectation of an increase in prices leads to a higher nominal wage, thereby making MC to rise. In turn this leads to a higher price level. The short run effect of increased government expenditure leads to a lower interest rate which facilitates higher output. If the price level does not increase, the shift in the money market becomes bigger. As such, the changes in the output cause adjustments in the global market prices (Anzuini 2007). Prolonged increase in prices in the medium run causes the MC of production to rise. This result into an upward shift in the commodity market up to the point the output achieves equilibrium at a new output level. In that case the increase in prices is proportionate to that of exports in the global market. The money market will shift downwards in the initial stages and returns to the original level as prices adjust. In the short run increased government expenditure leads to an increase in the output, a decline in the interest rate, and an upsurge in the price levels. While in the medium run such an increase is shown in the proportional increase in the price level. As this happens, it is noted that changes in the nominal money have no influence on the output or on the interest rates as such a policy is neutral to real variables, in the medium run. But it does not mean that MP cannot speed up the new equilibrium adjustments (Anzuini 2007). Changes in government expenditure causes shifts in the aggregate demand curve which cause temporary deviations from the national output. It is observed that in the medium run, this policy may be able to influence the national income depending on whether the policy can affect the demand and supply sides in the economy. In the case the policy does not affect the supply in the economy, the national output will return to its original position in the medium run. The composition of AD also changes depending on the strength and speeds of adjustments to changes in the fiscal policy (Anzuini 2007). In the short run model, whenever there is an adjustment, there results a feedback between the supply and the demand aggregates. A positive correlation between price and output leads an increase in the price level. Therefore, an increase in output increases employment which in turn decreases unemployment and increases wages. Wage increase eventually causes the price levels to increase. In the short run the output level needs to be at full employment as the expected price is known. Medium run adjusts the expected price levels making the AS curve to shift as the output adjusts along the aggregate demand (Anzuini 2007). Equilibrium in the AD-AS model Here at the equilibrium in the AD-AS market, AD will intersect SRAS in the short run to attain equilibrium while AD will intersect LRAS in the long run to attain equilibrium. At the general equilibrium, AD, LRAS, and SRAS will intersect in the same level (Anzuini 2007). 2 b. How hosting World cup event is likely to boost Brazilian government expenditure in 2014. When hosting an event like World cup and Olympics, preparation of several physical amenities comes in handy. Such amenities include, football pitches, transportation industry, hotels, security, communication systems among others. For the achievement of these, the government must increase its expenditure in order to achieve the economic, social, urban, and tourist impacts of such a mega sporting event. Preliminary results have indicated that the 2014 World Cup has attracted a budget of up to $ 15 billion (Anzuini 2007). It has been indicated that this huge sporting event will produce a remarkable economic effect in Brazil. This seen an improvement in the infrastructure, logistics, and security services by the Brazilian government. Currently, a number of urban infrastructure projects, rehabilitation and construction stages are ongoing by the government of Brazil. Of the proposed budget, 85.5% of it is funded by the Brazilian public sector while the private sector is funding 14.5%. As such the federal government being the main investor has put forward up to 61.1% of the total expenditure on the project. The main source of federal expenditure is through its budget. The expenses originating from federal budget adds up to R$ 7.0 billion which covers four main areas. Therefore the Brazilian government expenditure so far has more than doubled (Anzuini 2007). 3 a. Effects of Monetary stimulus on Employment, output, prices an interest rate. In the short run, IS and AD curves shift up due to the increase of the increase in the amount of autonomous consumption as a result of increase in the consumer confidence. As a result the output rises causing an increase in the level of transaction and in the demand for money. This causes the new equilibrium to be achieved at a higher level output level and higher interest rates. In the medium run the economy goes back to the original level (Boivin 2006). A rise in the money supply shifts the LM curve to the right. Increase in the money supply causes the interest rate to decline as the aggregate output rises. This is as a result of the excess money supply created by the decreases in the interest rates. This influences an increase in investment which results into an increase in both aggregate demand and aggregate output. The excess money supply is eliminated at the second equilibrium where both rise in output and decline in interest rate the quantity of money demanded offsets the money supply (Boivin 2006). An increase in the real money supply shifts the LM curve down and to the right A decline in money supply shifts the LM curve to left influencing the interest rate to rise and output to decreases. Change in fiscal policy is as a result of the rise in the aggregate output and an increase in the interest rate. It is noted that in the case of expansionary monetary policy the interest rate falls while it increases in the case of expansionary fiscal policy. An increase in government spending results to a direct increase in the aggregate demand. Higher levels of aggregate demand causes an increase in the quantity of money demanded which influences an increase in the interest rate (Faust 1998). With regard to prices, a rise in the level of aggregate output results into a fall in the price levels. This therefore leads to the development of the aggregate demand. Higher price level decreases the money supply and raises interest rates as the equilibrium in the goods market and money market are achieved. As such the conclusion is that ISLM model drawn from expansionary fiscal or monetary policy only affects the output in the short run and not in the long run. The aggregate demand curve stipulates the level of aggregate output at equilibrium for the goods and money market at a giv3en price level (Boivin 2006). The aggregate demand curve slopes downwards since a lower price level creates a higher money sully level while lowering the interest rates and raising the equilibrium output. The shifts in the aggregate demand curve, IS and LM curves shift in the same direction. When government spending increases and taxes decreases they shift to the right. Changes in real money supply are caused by drop in real money supply which shifts the LM curve to the left. The real change in money supply is when the nominal money supply changes with different rate than level of price (Boivin 2006). In real money demand, an increase in the demand for money shifts the LM curve up. While a drop in real money demand shifts the LM curve down to the right. A general equilibrium is achieved when all markets are simultaneously at equilibrium. It occurs at the intersection of IS and LM and FE curves in an economy (Faust 1998). General equilibrium in the IS-LM model In an event of supply shock, the marginal productivity of labor reduces and hence the demand for labor. Lower labor demand results into a fall in the equilibrium of real wage and employment level. Low employment and productivity reduces the equilibrium level of output resulting into a shift in of FE to the left (Faust 1998). References Alquist, R. and L. Kilian (2010), .What Do We Learn From the Price of Crude Oil Futures? Journal of Applied Econometrics, forthcoming. Anzuini, A., P. Pagano and M. Pisani (2007).Oil Supply News in a VAR: Information from Financial Market. New York: McGraw-Hill. Boivin, J. and M.P. Giannoni (2006). Has Monetary Policy Becomes More Effective? Review of Economics and Statistics. New York: John Willey & Sons. 88: 445-462. Faust, J. (1998). The Robustness of Identified VAR Conclusions about Money, Carnegie- Rochester Conference Series on Public Policy. Princeton: Princeton Publishers. 48: 207.44. Read More