Consumption - Production Model (Fiscal Policy Example)
Ceteris Parabus: if low unemp. P
(puts people back to work!)
Notes:
Using our consumption-production model, and assuming the economy is currently in equilibrium (sort of like it is now); what will be the affect of lowering taxes, ceteris paribus?
As taxes (T) are lowered (illustrated by the downward arrow in the slide above), then disposable income(Id) will probably increase (illustrated by the upward arrow in the slide above). As a result of the increase in disposable income, people now have more money to spend. Americans typically save around 5% of their pay, so around 95% of the increased money that Americans will have due to lower taxes will probably be consumed. This is generally true unless consumers are using this additional disposable income to reduce debt. Therefore, consumption (C) increases. As consumption becomes greater than production (P) in the short run, inventories (Iv) will start to fall.
Managers notice the decline in inventories, and realize they need to make adjustments to bring the system back into equilibrium. If the economy is currently experiencing low unemployment and factories are operating near capacity (like now), managers do not have many options in the short run. Managers will probably increase prices which may result in inflation. On the other hand, if unemployment was rather high and factories were operating at less than full capacity; then managers would probably choose to increase production by calling back laid off employees.
What about the affects of this cut in taxes on the deficit?