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Fiscal Policy & Macroeconomic Models Essay

1031 words - 5 pages


There are three macroeconomic models in which to analyze the effects of changes in fiscal policy: Keynesian, Monetarist and Classical.

Keynesian Model
The Keynesian model focuses on attempting to manage the “Demand” side of the economy by using taxation and spending to redistribute income and wealth. The rationale is that redistribution of income and wealth via taxation and use of transfer payments [government spending] will drive the “Demand” function thereby driving the overall economy. The Keynesian model makes no distinction between tax rates and tax revenues and assumes that government spending in the form of transfer payments will increase ...view middle of the document...

The Monetarist model assumes that a fixed annual growth rate in the supply of money by the nation’s central bank at a rate of 4% - 5% will allow for a natural or real economic growth rate of 2% - 3% plus an inflation factor that allows for price increases that minimize purchasing power risk [i.e., avoidance of too much money chasing too few goods]. The Monetarist approach believes that fiscal policy based on increased spending and taxes to drive demand will have the effect of “crowding out” private sector borrowing used for capital investment plus the ensuing loss of freedom from redistribution of income and wealth will adversely affect entrepreneurship. This, in turn, will create slower rather than faster economic growth.

Observations: Monetarist economics posits that budgets must be balanced [to avoid the “crowding out” effect], and that a combination of spending cuts and tax increases may be required to achieve this. This approach does not distinguish between a deficit arising from spending exceeding tax revenue versus a deficit arising from a reduction in marginal tax rates that over time historically increases the size of the overall economic base, thereby leading to an increase, rather than a decrease in tax revenue.

Classical Model
The Classical model focuses on the “Supply” side because the driving force for the economy is the incentive to pursue profit-maximizing activities. As such, production capacity is a function of price and not a fixed variable. Accordingly, if tax rates are reduced, this lowers the cost of capital formation and employment. Correspondingly, this increases the net return for work, investment and savings. The “wedge” or difference between the costs of hiring a worker versus the net-income received by that worker is reduced. Following the Rule of Demand, a lower price for work, savings and investment will lead to an increase in “Quantity demanded” for those factors. Similarly, the Rule of Supply demonstrates that a higher net-return for work, savings and investment will generate an increase in the “Quantity supplied” for those same factors. The tax-and-spend policies aimed at income and wealth redistribution will have the effect of reducing incentives for profit maximizing activities that, in turn contracts...

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