Question

 6. Keynesian demand-side versus supply-side effects

 Consider an economy operating below its full-employment output level. The government wants to enact a reduction in income taxes in an effort to restore the economy to full-employment output.

 On the graph that follows, shift one of the curves to illustrate the impact of the income tax cut on aggregate supply (AS) and aggregate demand (AD) that is emphasized by Keynesian economists.

 Note: Select and drag one or both of the curves to the desired position. Curves will snap into position, so if you try to move a curve and it snaps back to its original position, just drag it a little farther.

 On the graph that follows, shift one of the curves to illustrate the dominant impact of the income tax cut according to supply-side economists.

 Use the dropdown menus to fill in the following table to complete the causation chains for the Keynesian effects and supply-side effects of the income tax cut.

Answer 1

The government policy to deliberately influence the aggregate demand in the economy through changes in taxes or government spending or some combination of both is called the discretionary fiscal policy. The fiscal policy that increases aggregate demand by increasing government expenditure or by cutting the taxes or both is called the expansionary fiscal policy. If the policy decreases the aggregate demand by increasing the taxes or decreasing government expenditure, it is called contractionary fiscal policy.

Therefore, decreasing income taxes is expansionary fiscal policy that will increase the aggregate demand in the economy. As aggregate demand increases, given supply, the real GDP and inflation increases at new equilibrium. This is given in the figure below:

The supply side school of economic thought stresses on the importance of aggregate supply to change the output, employment and price level of the economy. The proponents of this school argue that the government should take the fiscal policy that affects the aggregate supply and hence corrects any disequilibrium in the economy. Given the demand a fall in supply means rise in overall prices and decrease in real GDP. Therefore, to combat inflation and increase real GDP at the same time the government should boost aggregate supply. The government can influence the aggregate supply by cutting the tax rate on income, reducing regulations, promoting research and development and subsidies. All of these will increase the workers incentive to work, cut the resource prices and encourage the producers to expand business and production. Thus, as the business expands more people will get job and supply will increase. Given demand this will also decrease the level of prices.