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Macroeconomics Models

Effects of Government Spending and Taxes

Governments have the ability to regulate their economies by using fiscal policy to affect components of aggregate expenditures that will affect the equilibrium GDP.

Recall that the components of aggregate expenditures are consumption, investment, government spending, and net exports. While the government is a factor that can directly influence aggregate expenditures and real GDP, it can also influence them indirectly by stimulating consumption, investment, and net exports.

An increase in government spending will increase both aggregate expenditures and real GDP, as more goods and services are purchased and more households must be employed to do so. This is considered a very important aspect in Keynesian theory, the model that states the economy is not self-adjusting, as spending can be used to close recessionary gaps (the difference between actual and potential GDP) and increase equilibrium GDP closer to full-employment GDP. A reduction in spending will decrease both aggregate expenditures and real GDP and can be used to close inflationary gaps.

In addition, the government can indirectly influence consumption and investment. In the case of consumption, a reduction in income tax rates will increase disposable income. The effect is an increase in consumption, which will increase aggregate expenditures and equilibrium real GDP. For the government to affect investment positively, it must increase confidence in the business environment and expectations of future profits. Governments can do this through the use of fiscal policy. By reducing business taxes or increasing subsidies, the government can incentivize investment in physical capital and increase expectations of future profits through a reduction of costs. Reducing or altering regulations may not only increase business confidence but will eventually reduce costs and increase aggregate expenditures. Changes in policy in the opposite direction will have the opposite effects. While changes in monetary policy will also affect investment levels through the manipulation of interest rates, this type of influence is controlled by the Federal Reserve and is independent of government spending and taxation.

The collection of taxes can have contradictory effects on the economy. Collecting taxes reduces disposable income, which reduces consumption. However, taxes are used to pay for government spending and meet debt obligations, and government spending is an injection into the economy. If the amount of government spending is more than the amount of taxes collected, that is, if expenditures are greater than revenues (known as deficit spending), the overall result is an injection into the economy and an increase in equilibrium GDP.