2. Tax Cuts and the Recession of 2001
The debate over the tax cuts during the recession of 2001 was broader than whether the tax cuts should be permanent. Many economists argued that a stimulus package would be most effective when aimed at those with high propensities to consume. It seems reasonable to assume that low income taxpayers would have higher propensities to consume than high income taxpayers. This implies that tax cuts would be more effective when targeted toward low income taxpayers. The Bush tax cuts were not targeted toward low income taxpayers. An exercise at the end of Chapter 3 examines this issue from the point of view of the Keynesian cross model.
VII. Observations
The interest rate plays a critical role in the closed economy IS-LM model. First, the interest rate is the channel through which monetary policy affects output. Second, the effect of fiscal policy on the interest rate limits the ability of fiscal policy to influence output. On the latter point, it is worthwhile to compare the output effects of an increase in G in the Keynesian cross model (modified to include endogenous investment) to the effects of the same policy in the IS-LM model. An increase in G shifts the IS curve to the right. The horizontal shift at the initial interest rate is the change in output from the Keynesian cross (see Figure 5.2). Clearly this is larger than the change in output from the IS-LM model, unless the LM curve is horizontal. In the IS-LM model, the increase in G leads to an increase in the interest rate, which tends to reduce investment. The interest rate effect is not present in the simple Keynesian cross model.
Figure 5.2: Fiscal Expansion in the Keynesian Cross and the IS-LM Models
