Increased government
purchases, with taxes held constant, can eliminate a contractionary gap.
How could a tax cut achieve the same result? Would the tax cut have to
be larger than the increase in government purchases? Why or why not?
To understand how a tax cut can achieve the same result as increased government purchases in eliminating a contractionary gap, we need to first clarify what a contractionary gap is. A contractionary gap occurs when an economy is operating below its potential output or facing recessionary conditions.
When there is a contractionary gap, one way to stimulate the economy is through fiscal policy, which involves adjusting government spending and taxation. The two key tools of fiscal policy are government purchases and taxes. Let's look at how each of these tools can be used to close the contractionary gap:
Increased government purchases: When the government increases its purchases of goods and services, it injects money into the economy, which in turn stimulates aggregate demand. This can help boost economic activity and reduce the contractionary gap.
Tax cut: A tax cut involves reducing the tax rates or providing tax credits to individuals or businesses. This puts more disposable income in the hands of taxpayers, which can lead to increased consumer spending and private investment. The increased spending and investment can also stimulate aggregate demand and help eliminate the contractionary gap.
Now, to answer your question: Does the tax cut have to be larger than the increase in government purchases?
The answer is not necessarily. Both increased government purchases and tax cuts can have a similar impact on aggregate demand, but they affect different sectors of the economy.
When the government increases its purchases, it directly stimulates the public sector, as it spends money on goods and services. On the other hand, a tax cut benefits taxpayers, who are part of the private sector. People can choose how to spend or save the extra money they receive from the tax cut.
The size of the tax cut needed to achieve the same result as increased government purchases depends on several factors, including the multiplier effect, consumer behavior, and the initial situation of the economy. The multiplier effect refers to the idea that an initial injection of spending leads to successive rounds of spending as the money circulates through the economy.
In some cases, a tax cut may need to be larger than the increase in government purchases to achieve the same impact on aggregate demand if the multiplier effect is relatively small or if consumer spending is not very responsive to changes in income.
However, the specific size of the tax cut relative to the increase in government purchases would depend on an analysis of the multiplier effect, the spending patterns of individuals and firms, and other economic factors. Economists and policymakers would consider these factors when determining the appropriate size of the tax cut or increase in government purchases to close a contractionary gap effectively.
In summary, while both increased government purchases and tax cuts can help eliminate a contractionary gap, the size of the tax cut relative to the increase in government purchases would depend on various factors specific to the economy in question. It may or may not need to be larger, and this determination requires careful analysis and consideration of the multiplier effect and consumer behavior.
Do a little research, then take a shot. What do you think?
Hint: be sure to read up on the money multiplier.