The fiscal policy tools used by the federal government to manage the U.S. econom
ID: 1094126 • Letter: T
Question
The fiscal policy tools used by the federal government to manage the U.S. economy are (1) changes in income taxes and (2) changes in government spending. Explain what the government would do with these tools if it wanted to expand (grow) the economy, using Keynesian economic theory. What would the effect of these changes be on each of the following: total money supply, loans available to individuals and small businesses, demand, production, employment, and the total amount of income tax dollars collected by government.
Explanation / Answer
Change in income taxes
If the government wants the economy to grow, it will reduce the income taxes, which will increase the disposable income and hence increase the consumption. This will lead to rise in aggregate demand and thus, output will increase.
Change in government expenditure
Increase in spending by government will lead to rise in aggregate demand which will increase the output and hence, economy will expand.
In both cases, interest rate will increase, demand will rise, production will rise and employent will also rise.
Increase in government spending should be short term because it leads to a crowding out effect by increasing the interest rates and hence, reducing the private investment level. Also high growth of demand relative to supply will lead to unwanted levels of inflation.
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