Here is another real world application of the Keynesian Aggregate Expenditure (A

Question

Here is another real world application of the Keynesian Aggregate Expenditure (AE) model and Aggregate Demand (AD) model you have studied in Chapter 11 and 12 of our text book.  Please read the following text and answer the questions to the best of your knowledge.

President Trump promised to boost the economy both by cutting taxes and investing more money in infrastructure. Usually, however, politicians and policymakers have favored one type of stimulus over the other.

Some conservatives believe that tax cuts to the rich will create more investment and jobs in the economy. Some liberals favor more government spending to stimulate the economy through infrastructure, education, and healthcare. There are moderates who believe a combination of specific tax cuts and increase in specific government spending is essential to stimulate the growth of our economy.

In the Trump administration, tax cuts appear to have won the argument for now. Republicans unveiled the blueprint of a major tax overhaul, which White House officials predict will boost economic growth to more than 3 percent a year. In the meantime, infrastructure investment remains on the back-burner.

Based on your informed opinion, did they make the right choice pushing for tax cuts before infrastructure spending? Are tax cuts more likely than new spending to encourage companies to produce more, encourage more consumer spending and grow the economy at a faster rate? Which policy provides the biggest bang for the buck?

Explanation / Answer

The government earns from the tax revenues and spends it in on public goods and various program including transfer payments. Now if the revenues from tax exceeds the government expenditure a budget surplus results. On the other hand if the government spending exceeds its revenue the budget deficit results.

The increase in any autonomous part of expenditure set out a multiplier process and increases the real GDP by the multiplier time of initial increase in government purchase. On the other hand the decrease in taxes has an indirect effect on real GDP. A decrease in taxes increases the disposable income; only one part of the increased disposable income is used as consumption. Hence consumption increases less than the decrease in tax and increases aggregate demand. Thus decrease in tax has indirect effect on aggregate demand and decrease in taxes results in less increase in aggregate demand than same increase in government spending.

Thus an equal dollar increase in aggregate demand will increase the aggregate demand more than an equal dollar increase in taxes will decrease aggregate demand. Then as the net effect the aggregate demand will increase. Therefore, the government could do better with increase in government spending to boost the economy rather than the tax cut.

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