There are two types of Fiscal policy put in place to alter the level of aggregate demand; Expansionary fiscal policy and Contractionary fiscal policy. When an economy is in a recession, expansionary fiscal policy is in order. Typically this type of fiscal policy results in increased government spending and/ or lower taxes. A recession results in a recessionary gap meaning that aggregate demand is at a level lower than it would be in a full employment situation. In order to close this gap, a government will typically increase their spending which will directly increase the aggregate demand curve (since government spending creates demand for goods and services).
Demand side policies are those that manipulate the level of aggregate demand (AD) to achieve one or more economic objective. The policies can be fiscal policies (changes in government spending and/or taxation), or they might be monetary policies (which are largely changes in the short-term rate of interest). The four major macroeconomic objectives are a sustainable level of economic growth; low inflation; low unemployment; and a medium term balance on current account. Recently the government have used loose fiscal policy and the MPC have reduced the rate of interest. These are designed to increase the level of AD and increase in national income.
Policies are imposed in an economy to promote economic growth which is increasing real GDP. Policies essentially either aim to increase in aggregate demand or aggregate supply. There are demand side policies and supply side policies. Demand side policies become important during recession or period of economic stagnation. Supply side policies are important for determining long run growth in productivity.
Fiscal policy concerns the use of changes in the amount of taxation (T) and government spending (G) to influence the national economy. Changing G will directly affect aggregate demand as AD calculated through the equation AD = C + I + G + (X-M). Not only does fiscal policy affect AD but also aggregate supply, however the affect on AD will be much more immediate whereas AS is affected indirectly over a longer period of time. Monetary policy concerns three main methods of government intervention in an economy; changing the money supply, changing interest rates and the exchange rate. Monetary policy will also indirectly affect AS, as well as directly affecting AD.
Therefore, when the aggregate demand compared with the economic production capacity is quite low, expansionary monetary policy should be taken into use appropriately. Negative monetary policy is to reduce the level of aggregate demand by cutting the growth rate of money supply. In this policy, it is difficult to obtain the credit and the interest rate increases as well. Therefore, when the inflation is serious, the negative monetary policy is more appropriate. (Stanley Fischer,1993) Monetary policy includes seven aspects: I. controlling the amount of currency issue.
The GDP value would then decrease, due to the move from Point A to C, and increase employment which would decrease savings. In addition, there is an inverse relationship to both bond prices and interest rates because as one increase in value, the other decreases, and vice versa. 2. IS-LM Model--Suppose that you have the following equations for the IS-LM model. The following are the equations of the IS-LM model, here including a feature that taxes are not simply given but depend on income through a tax function, T(Y).
Price inflation causes the value of a dollar to fall over time, and so the same dollar amount in two different years will usually represent different amounts of purchasing power. To counteract this problem, analysts typically adjust dollar figures to account for inflation. Figures that have not been adjusted for inflation are said to be in 'nominal dollars,' while those that have been adjusted are in 'real dollars. Using the nominal dollar does not give the correct short run cost estimaate. Following graph depicts the effect of inflation on cost One of the method firms use for adjusting for inflation is by deflating nominal cost data using an implicit price deflator.
Hence, the relevant corporate tax rate has to be the effective tax rate and not the statutory tax rate. DeAngelo and Masulis cite the findings of Corcoran2 and Holland and Myers3 based on the time series of effective tax rates, that firms use more debt during inflationary periods. This is because inflation increases the corporate tax rate due to the decrease in the real value of deductions that are based on historical book value. Similarly, Fame4 and Gonedes5 also give indirect evidence on the tax effects of inflation on historical costs. Based on the theoretical hypothesis of DeAngelo and Masulis, the following hypothesis is framed to test the relationship between corporate