4.1 Fiscal policy

Let´s suppose, the state decides to reduce the budget deficit. To achieve this goal, it either increases taxes T or reduces government expenditure G. Such a measure is called contractionary fiscal policy or budget consolidation. In contrast, there is the expansion of the budget (deficit), called expansive fiscal policy, either by increasing government expenditure G or by reducing taxes T.
In the following we analyze budget consolidation through a tax increase, while government expenditure remains unchanged. With the other two controllers in the graph, other fiscal policy measures can be adjusted and analyzed.
The first question is how the tax increase affects the balance on the goods market and thus the IS curve. Looking at the initial state, that is, unchanged interest rate i0 with income Y0, consumers have less disposable income after the tax increase. Thus, the tax increase dampens consumption, and, as a result of the multiplier effect, income decreases. Production decreases. In general, for any interest rate, the higher taxes lead to lower income and the IS curve shifts to the left. Since taxes T do not enter into the LM equation, they cannot shift the equilibrium condition on the money and financial markets and the LM curve is not affected by this type of fiscal policy.
In the graph, the IS and LM curves intersect at Eq0 , the initial equilibrium. Because of the tax increase the IS curve shifts to the left. The new equilibrium point Eq is the intersection of the new IS curve and the unchanged LM curve. As a consequence of the shift of the IS curve, the economy moves along the LM curve from Eq0 to Eq.
Let us assume in a thought experiment that the interest rate would not fall to i.Then, the economy would move horizontally from point Eq0 to the intersection of the i0-line with the LM curve and the economy would shrink more significantly. However, since the interest rate does fall and therefore the demand for goods is stimulated, the decline in production is less and only falls to the point Eq.
Now, let us summarize what the graph depicts in the case of a tax increase: the tax increase reduces disposable income. Therefore, economic actors restrict their consumption. The multiplier effect reduces income, which in turn reduces money demand. As a result, the interest rate falls. The lower interest rate stimulates investment and thus mitigates the effects of the tax increase on the demand for goods, but cannot completely compensate them.

Finally, we analyze the partial effects of a tax increase on the individual components of the demand for goods. Consumption declines because the disposable income declines for two reasons, firstly because of the tax increase, and secondly because income declines.
At this point, the effect of a tax increase on investment activity is not evident. On the one hand, sales are declining because of lower income, which leads to lower investment activity. On the other hand, the lower interest rate stimulates investment activity. Which effect dominates after a tax increase can only be determined by an exact quantitative specification of the model.
In the event of a tax increase, as described above, the IS curve shifts to the left, income decreases, as well as the interest rate. If the tax is lowered, the opposite effect occurs and the IS curve shifts to the right, income and interest rate increase.
If government expenditure increases, similar processes occur. Here, the IS curve shifts to the right, income and interest rates rise. <br /> With a decrease in government expenditure, the IS curve shifts to the left, the same effects occur as with a tax increase and income and interest rate decrease.
The fiscal policy measures presented here have an additive effect when applied simultaneously, i.e. they can reinforce each other if they act in the same direction or dampen each other (even cancel each other out) if they act in the opposite direction. An increase in government expenditure financed by higher taxes has no effect on the IS curve (if the amounts are balanced), since the higher government consumption is compensated by the lower private consumption. To see this, one can move the sliders for government expenditure or taxes all the way to the right or left. On the other hand, if the government pursues a very expansive fiscal policy, it will increase government spending and decrease taxes. Government and private consumption will fuel the economy and the IS curve will shift to the far right. GDP and interest rates rise sharply. Here, the increase in interest rates makes this type of deficit-financed growth stimulus particularly expensive.

(c) by Christian Bauer
Prof. Dr. Christian Bauer
Chair of monetary economics
Trier University
D-54296 Trier
Tel.: +49 (0)651/201-2743
E-mail: Bauer@uni-trier.de
URL: https://www.cbauer.de