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Expansionary Monetary Policy

Expansionary fiscal policy, such as the Chancellor of the Exchequer deciding to reduce the standard rate of income tax leads to higher aggregate demand and an increase in equilibrium income and output. In this essay I will examine the factors that are important in determining the macroeconomic effects should such a policy be installed by Gordon Brown (Chancellor of the Exchequer), and I will comment on any suggestions I may have for Gordon Brown in the preparation of his next budget with a brief description on the assumptions that my advice is based.

Macroeconomic Goals
Firstly I would like to examine the macroeconomic goals/aims of Gordon Brown and his fiscal policy. Fiscal policy is the governments plan for spending and taxation, it is designed to steer aggregate demand in some desired direction, which we will investigate in greater detail later on today. Macroeconomic policy is a phrase used to describe actions taken by governments to manipulate the economy to influence the level of inflation and unemployment. Along with balance of payments and high stable economic growth, low inflation and high employment are two of the main four macroeconomic goals of the government. In practice, macroeconomic policies could be used to refer either to policies sought to influence aggregate supply or to policies that sought to influence aggregate demand. We will investigate aggregate supply and aggregate demand both in the long run and in the short run and show their effects on macroeconomic policy.

Aggregate Supply and Aggregate Demand
Aggregate Demand and Aggregate Supply in the Long Run as shown in Figure 1

Figure 1

In this graph we can see that as a result of a decrease in income taxes, aggregate demand will shift to the right from AD to AD1. Aggregate supply in the long run is a vertical line that keeps Y at the natural rate of Y*, which inturn produces constant output and increased prices which is an affect of increased inflation.

Aggregate Demand and Aggregate Supply in the short run as as shown in figure 2.
Figure 2

Here we can see that aggregate supply in the short run is a horizontal line. An increase of the aggregate demand curve form AD to AD1 results in increased output should income taxes be decreased while keeping the price level constant at P*. In this example Gordon Brown is able to achieve at least 3 of his 4 macroeconomic goals. Growth being the obvious as output increases from Y to Y1, increased growth produces jobs hence increased employment, all while the price level stays constant at P* which signifies stable inflation.
Lucas had a theory related to the above that is shown in figure 3.

Figure 3

Lucas shows in figure 3 that a decrease in income taxes will lead to an increase in aggregate demand, shown AD to AD1. An increase in aggregate demand leads to an increase in the demand for labour shown as a shift from DL to DL1 which leads to increase in employment as a result of the wage rate increasing from 1 to 2. However, due to the natural rate of unemployment the supply of labour shown as SL, shifts to the right to SL1 where the wage rate is represented as 3 and employment returns to the natural rate.

IS-LM Model
This example of short run and long run aggregate supply and demand brings us straight into IS-LM Model. The IS-LM Model shows the combinations of both income and interest rates and shows how equilibrium is reached in both the goods and money markets. This model involves two schedules/curves, the IS curve and LM curve. The IS schedule shows the different combinations of income and interest rates at which the goods market is in equilibrium and the LM schedule displays the combinations of interest rates and income compatible with equilibrium in the money market. Figure 3 shows an IS-LM schedule in equilibrium or the goods and money markets in equilibrium.

Figure 4

The money market is in equilibrium at all points on the IS curve. The money market is in equilibrium at all points on the LM curve so only at point A are both markets in equilibrium.

With the exception of a fall in interest rates, any factor that shifts the aggregate demand curve upwards, such as a decrease in income taxes will also shift the IS curve upwards as well. Figure 4 is an example of expansionary fiscal policy and its results on IS-LM model.

Figure 5

In Figure 4 we analyze the results of a decrease in income taxes. We see that the decrease in taxes shifts the IS schedule from IS to IS1 but leaves the LM schedule untouched. This fiscal expansion moves the equilibrium along the LM curve from E to E1. Interest rates increase and partly crowd out private investment, but despite this Income still manages to increase from Y to Y1. The government however could use expansionary monetary policy by increasing the money supply and shifting the LM schedule from LM to LM1 to prevent a raise in interest rates. This would then bring the new equilibrium level to E2, increasing the income equilibrium to Y2 canceling out the crowding out of private investment and consumption due to the lower interest rates.

Ricardian Equivalence

The traditional aggregate supply and aggregate demand model makes the picture of reducing income tax very clear: Lower taxes means higher aggregate demand, higher interest rates, crowding out, and less investment for the future. However, new classical economists and David Ricardo come up with a different solution. The Ricardian Equivalence states that debt financing by bond issue merely postpones taxation and therefore, in many circumstances is strictly equivalent to current taxation.
An example of this is where the government cuts taxes by $500 million, however to cover this loss in revenue the government issues $500 million in government bonds. The bonds do come at a cost because bonds are valued at their present value plus the value of future interest payments to the holder of the bond. The bond will have to be paid back plus interest, and to find these funds when the bond is converted the government will simply raise taxes. Essentially a decrease in income tax to the private sector today is a nice bonus, but this bonus in the long run will be matched be an equal penalty of increased taxes to makeup for the initial cut. This tells us that the private sector is neither richer or poorer as a result of this tax cut, and hence will not change desired spending and has no effect on aggregate demand. The theory of rational expectations, which are forecasts, and although they may not necessarily be correct, are the best that can be made given the available data. The relevance of rational expectations is displayed in the Ricardian Equivalence in that a tax cut will not increase my disposable income because I will anticipate an increase in taxes in the long run to offset the initial cut and the extra income from the reduction of taxes will go entirely into savings to pay taxes at a later date.

Current U.K. Macroeoconomic Environment

The current condition of the U.K. macroeconomic environment is very healthy. The current labour market position in the U.K. is encouraging. Economic growth and low inflation has resulted in strong employment growth and a corresponding fall in unemployment. Employment is at record levels and long run unemployment is at its lowest level for nearly twenty years. Female employment is currently at its highest rate ever of 68.6%, while the U.K. labour market compares nicely with the EU and is below the rates of both Japan and the U.S. The pound is very strong and trading favourably against the dollar and the euro.

Advice to Gordon Brown

Everyday the newspapers and television refer to the problems of inflation, unemployment, and slow growth, which are three of Gordon Browns biggest goals. Gordon Brown is therefore always under the microscope and with an election not far away he wants his policies to be fast acting and make him look favorable in the public eye. The economy currently is prospering so my initial advice to Mr. Brown would be to leave a good thing alone and leave the income tax rate as is. However coming up on an election Mr. Brown wants to show me that he’s doing something for me and a tax cut will be looked upon favorably in the public eye. Mr. Brown might consider cutting taxes and in the long run as discussed above the economy will keep the price level constant et increase output, he can deal with fixing the long run consequences of an increased price level and a return to the natural rate of Income after he is elected. To the non-economist a decrease in taxes will seem beneficial due to the increase in aggregate demand: Output will increase, employment will increase as will the wage rate, all while the interest rate stays constant. Assuming that Mr. Brown doesn’t have any personal goals and is solely interested in the well being of the U.K. economy I would suggest to keep the current fiscal policy, for reasons backed up by the Ricardian Equivalence and the fact that the current macroeconomic conditions in the U.K. are favorable and don’t need to be fixed.

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