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Fiscal Policy & Macroeconomic Models

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FISCAL POLICY & MACROECONOMIC MODELS

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 or decrease demand based on the level of spending AND the spending multiplier. The spending multiplier can be expressed mathematically as:

Spending Multiplier = 1 / (1 – MPC) in which
MPC is the “marginal propensity to consume.”

Keynesian economics is based on the view that lower income brackets have higher MPC, while higher income earners have lower MPC. Accordingly, the transfer of income and wealth to lower income earners will transfer into increased economic growth because every dollar of transfer payments in theory will have a higher multiplier effect. The increase or decrease of “taxes-and-spending” should accelerate [or decelerate] economic growth depending on how it is applied.

Observations: Keynesian economics ignores or does not take into account that changes in tax rates and income/wealth redistribution will directly affect incentives to work, save and invest. Keynesian economics assumes that production capacity in the overall economy is a fixed variable and that capacity utilization rate can be increased or decreased via the use of fiscal policy. Keynesian economics posits that there is a tradeoff between growth and inflation.

Monetarist Model
The…...

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