Fiscal Policy-Supply Side Effects

Government Spending

A) purchases of goods and services: public goods

For public goods one person’s consumption does not reduce another’s consumption

very costly or impossible to exclude one person from consumption, but not another

e.g. national defense also police, fire protection, justice system, infrastructure, basic science research

If the private sector is responsible for producing these types of goods then production would be lower and more costly

Government provision of these products allows firms and households to be more productive.

How do we use the AS/AD model to show this increase in productivity?

The long run aggreate supply curve is farther to the right than it would have been if governments did not provide these goods. The price level is lower and the potential output level is higher.

Government spending on transfer payments

1) Unemployment Compensation as seen before in lecture, on the exam and on worksheets

The duration of unemployment rises, the natural rate of unemployment rises and the potential level of output falls as represented by a shift to the left by the LRAS curve.

2) Welfare payments -encourages some people not to work at all. The supply of labor falls and the potential level of output falls. This is represented by a leftward shift in the LRAS.

3) Social Security- If people believe that they will get benefits when they retire then savings of working people falls. If SS was actuarially sound the SS tax payments would be saved by the government and savings would not be affected but under a pay as you go system the taxes are not saved.

This decrease in savings means that interest rates are higher than they would be otherwise and investment is lower. But lower investment means that the rate of capital accumulation is slower so that the capital stock falls or is less than it would have been otherwise. Thus, the potential rate of output either falls or is lower than it would have been other wise and the LRAS shifts to the right but not by as much as it would have shifted if .

Summary government spending on public goods means that potential output is higher than it would be otherwise and that the price level is lower than it would be other wise. Recall the point made by Krugman’s article about the limits of growth at a given point of time.HBR etc

Government spending on transfers means that potential output falls and the price level rises.


A) taxes on workers wages imply that the supply of labor falls and the the potential level of output falls and the NAIRU falls.

B) Taxes on the return from savings that is on interst dividend, capital gains etc. will have the following effect



tax shifts the supply of loanables to the left

borrowers must pay a higher rate of return, the gross r1

savers receive lower rate of return, the net r1.

As a consequence investment falls and potential output falls andthe price level rises.

Short run impact

The long run effect of higher interest rates is to reduce the rate of growth in the economy

At a higher interest rate LRAS 1 may only be possible whereas if the interest rate where lower LRAS 2 would have been possible.

Summary Higher taxes on labor return from savings implies that potential output falls. Lower taxes on labor and the return from saving implies that potential output rises.

tax changes tend to have the offsetting effects on P.

But also tax cuts tend to increase AS which reduces the price level.



Laffer Curve

If the tax rate is 0% then tax revenue is 0

If the tax rate is 100% then tax revenue is 0 (no one would work)

If the tax rate is high such as at point A and if the tax rate is reduced to point B, then revenue will increase.

Note that the tax revenue is equal to the product of the tax rate and the tax base.

tax revenue=(tax rate)x(tax base)

a fall in the tax rate can increase the potential level of output and this increase in the tax base offsets the reduction in the tax rate.

if the tax rate is low such as at point C and if it is cut to point D then tax revenue will fall.

Government Deficits

A. Government Borrowing can crowd out private investment, which leads to a reduction in the rate of capital accumulation. The potential level of output is not as great as it would have been otherwise and the price level is higher than it would have been otherwise.