Let´s suppose, the state decides to reduce the budget deficit. To achieve this
goal, it either increases taxes T or reduces government expenditure G. Such a
measure is called contractionary fiscal policy or budget consolidation. In
contrast, there is the expansion of the budget (deficit), called expansive fiscal
policy, either by increasing government expenditure G or by reducing taxes
T.

In the following we analyze budget consolidation through a tax increase,
while government expenditure remains unchanged. With the other two
controllers in the graph, other fiscal policy measures can be adjusted and
analyzed.

The first question is how the tax increase affects the balance on the goods market
and thus the IS curve. Looking at the initial state, that is, unchanged interest rate
$i0$ with
income $Y0$,
consumers have less disposable income after the tax increase. Thus, the tax
increase dampens consumption, and, as a result of the multiplier effect, income
decreases. Production decreases. In general, for any interest rate, the higher taxes
lead to lower income and the IS curve shifts to the left. Since taxes T do not enter
into the LM equation, they cannot shift the equilibrium condition on the money
and financial markets and the LM curve is not affected by this type of fiscal
policy.

In the graph, the IS and LM curves intersect at
$\mathit{Eq}0$ , the initial
equilibrium. Because of the tax increase the IS curve shifts to the left. The new equilibrium
point $\mathit{Eq}$
is the intersection of the new IS curve and the unchanged LM curve. As a
consequence of the shift of the IS curve, the economy moves along the LM curve
from $\mathit{Eq}0$
to $\mathit{Eq}$.

Let us assume in a thought experiment that the interest rate would not fall to
$i$.Then,
the economy would move horizontally from point
$\mathit{Eq}0$ to the intersection
of the $i0$-line
with the LM curve and the economy would shrink more significantly. However,
since the interest rate does fall and therefore the demand for goods is
stimulated, the decline in production is less and only falls to the point
$\mathit{Eq}$.

Now, let us summarize what the graph depicts in the case of a tax increase: the
tax increase reduces disposable income. Therefore, economic actors restrict
their consumption. The multiplier effect reduces income, which in turn
reduces money demand. As a result, the interest rate falls. The lower
interest rate stimulates investment and thus mitigates the effects of the tax
increase on the demand for goods, but cannot completely compensate
them.

Finally, we analyze the partial effects of a tax increase on the individual
components of the demand for goods. Consumption declines because the
disposable income declines for two reasons, firstly because of the tax increase, and
secondly because income declines.

At this point, the effect of a tax increase on investment activity is not
evident. On the one hand, sales are declining because of lower income, which
leads to lower investment activity. On the other hand, the lower interest
rate stimulates investment activity. Which effect dominates after a tax
increase can only be determined by an exact quantitative specification of the
model.

In the event of a tax increase, as described above, the IS curve shifts to the left,
income decreases, as well as the interest rate. If the tax is lowered, the opposite
effect occurs and the IS curve shifts to the right, income and interest rate
increase.

If government expenditure increases, similar processes occur. Here, the IS
curve shifts to the right, income and interest rates rise. <br /> With a
decrease in government expenditure, the IS curve shifts to the left, the
same effects occur as with a tax increase and income and interest rate
decrease.

The fiscal policy measures presented here have an additive effect when
applied simultaneously, i.e. they can reinforce each other if they act in the
same direction or dampen each other (even cancel each other out) if they
act in the opposite direction. An increase in government expenditure
financed by higher taxes has no effect on the IS curve (if the amounts are
balanced), since the higher government consumption is compensated by
the lower private consumption. To see this, one can move the sliders for
government expenditure or taxes all the way to the right or left. On the other
hand, if the government pursues a very expansive fiscal policy, it will
increase government spending and decrease taxes. Government and private
consumption will fuel the economy and the IS curve will shift to the far
right. GDP and interest rates rise sharply. Here, the increase in interest
rates makes this type of deficit-financed growth stimulus particularly
expensive.

(c) by Christian Bauer

Prof. Dr. Christian Bauer

Chair of monetary economics

Trier University

D-54296 Trier

Tel.: +49 (0)651/201-2743

E-mail: Bauer@uni-trier.de

URL: https://www.cbauer.de