CH 22 ECONOMIC GROWTH
How Potential GDP Grows
Potential GDP is the level of real GDP when the quantity of labour employed is the full-employment quantity.
To determine potential GDP; we use a model with two components:
• An aggregate production function – the relationship on how real GDP changes as the quantity of labour changes.
• An aggregate labour market – the relationship between real wage rate and the quantity of labour.
- Real wage rate is the money wage rate divide by the price level and is the quantity of goods and services that an
hour of labour earns.
- Money wage rate is the number of dollar that an hour of labour earns.
Potential GDP is at labour market equilibrium which can also be shown on the production function.
What Makes Potential GDP Grow?
• Growth of the supply of labour
- Quantity of labour = # of workers employed × average hours per worker
- # of workers employed = employment-to-population ratio × working-age population.
1. Average hours per worker
2. The employment-to-population ratio
3. The working-age population
- Growth in the supply of labour has come from growth in the working-age population, but in the long-run,
working-age population grows at the same rate as the total population.
- These effects shifts the supply curve and moves along the production function
• Growth of labour productivity – is the quantity of real GDP produced by an hour of labour. It is calculated by dividing
real GDP by aggregate labour hours.
1. Physical capital growth
2. Human capital growth
3. Technological advances
- Shifts the demand curve and stretches the production function.
Growth Theories, Evidence, and Policies
• Classical growth theory – is the view that growth of real GDP per person is temporary and that when it rises above the
subsistence level, a population explosion eventually brings it back to the subsistence level.
• Neoclassical growth theory – is the proposition that real GDP per person grows because technological change induces
saving and investment that make capital per hour of labour grow. Growth ends if technological change stops.
• New growth theory – holds that real GDP per person grows because of the choices people make in the pursuit of profit
and that growth will persist indefinitely. CH 26 AGGREGATE SUPPLY AND AGGREGATE DEMAND
Aggregate Supply – is the relationship between the quantity of real GDP supplied and the price level
• Long-run aggregate supply (Potential GDP) – is the relationship between the quantity of real GDP supplied and the
price level when the money wage rate changes in step with the price level to maintain full employment.
- Price level and money wage rate change by the same percentage, movement up/down along the curve.
• Short-run aggregate supply – is the relationship between the quantity of real GDP supplied and the price level when
the money wage rate, the prices of other resources, and potential GDP remain constant.
- Price level changes but money wage rate is unchanged, movement along the curve.
• Real GDP > Potential GDP when to the right of the equilibrium
• Real GDP < Potential GDP when to the left of the equilibrium
1. Change in potential GDP shifts both LRAS and SRAS.
a. An increase in the full-employment quantity of labour
b. An increase in the quantity of capital
c. An advance in technology
2. Change in money wage rate or the money price of any other factor of production shifts SAS (Rise shifts leftward
and fall shifts rightward)
a. Departures from full employment
i. unemployment above natural rate puts downward pressure on the money wage rate and
unemployment below natural rate puts upward pressure on the money wage rate
b. Expectations about inflation
i. Expected rise in inflation makes the money wage rate rise faster and expected fall in inflation
slows the rate at which the money wage rate rises
o Does not change the LRAS because the change in the money wage rate is accompanied by an equal
percentage change in the price level
The quantity of real GDP demanded is the total amount of final goods and services produced in Canada that people,
businesses, governments, and foreigners plan to buy. These buying plans depend on many factors.
1. The price level
3. Fiscal policy and monetary policy
4. The world economy
Aggregate demand – the relationship between the quantity of real GDP demanded and the price level.
- An aggregate demand schedule and an aggregate demand curve describe aggregate demand
- The aggregate demand curve slopes downward for two reasons:
1. Wealth effect (price level rises means real wealth decreases)
2. Substitution effect (price level rises means interest rates rise therefore we substitute our buying plans
- Price level changes bring movement along the curve.
Changes in aggregate demand – a change in any factor that influences buying plans other than the price level
1. Expectations (rise in future inflation or income results in an increase in AD)
2. Fiscal policy (government’s attempt to influence the economy by setting and changing taxes, making transfer
payments, and purchasing goods and services) – unemployment benefits or welfare payments increase AD and
monetary policy (the Bank of Canada’s attempt to influence the economy by changing interest rates and the
quantity of money) – an increase in the quantity of money increases AD through two main channels: it lowers
interest rates and makes it easier to get loans, and
3. World economy – a decrease in exchange rate (exports increase and imports decrease) and an increase foreign
income (increases exports) increases AD
Explaining Macroeconomic Trends and Fluctuations
Short-run macroeconomic equilibrium – occurs when quantity of real GDP demanded equals supplied (AD = SAS)
- If below SR equilibrium, firms increase production and prices and opposite for above.
Long-run macroeconomic equilibrium – occurs when real GDP equals potential GDP (AD = LAS)
- If the money wage rate is high or low (SAS to the left/right) then it adjusts in the long run Economic Growth and Inflation
- AS-AD model explains economic growth as increasing LAS and inflation as persistent increase in aggregate
demand at a faster pace than that of the increase in potential GDP.
The Business Cycle in the AS-AD Model
Above full-employment equilibrium – Inflationary gap, real GDP exceeds potential GDP (equilibrium to the right of LAS)
Full-employment equilibrium – real GDP equals potential GDP (equilibrium at LAS)
Below full-employment equilibrium – recessionary gap, potential GDP exceeds real GDP (equilibrium to the left of LAS)
Fluctuations in Aggregate Demand
- One reason real GDP fluctuates around potential GDP is that AD fluctuates
- An increase/decrease in AD in short-run leads to a SAS movement up/down along the AD curve
o Increase in AD -> Firms increase production and prices -> Inflationary gap -> Firms must raise money
wage rate (which shifts SAS up along the AD curve)
o Leads to higher price level and no change in potential GDP in the long run
Fluctuations in Aggregate Supply
- Fluctuations in SAS can bring fluctuations in real GDP around potential GDP as well
- At full employment the prices of factors of production rise and SAS shifts to the left
o Because of the price level rising, the economy experiences inflation and because of a decrease in real
GDP, the economy experiences a recession this is known as stagflation.
When the price of factors of production return back to normal levels, the economy returns to
Macroeconomic Schools of Thought
1. Classical – believes in self-regulating and always at full employment
New Classical – business cycle fluctuations are the efficient responses of a well-functioning market
economy that is bombarded by shocks that arise from the uneven pace of technological
o Technological change is the most significant influence on both AD and AS, which is why they don’t use
the AS-AD framework (it increases productivity of capital and lengthens the life of existing capital,
explaining the increase and decrease in AD)
o Money wage rate for the SAS is instantly and completely flexible and adjusts so quickly to maintain
equilibrium that real GDP always equal potential GDP.
o Potential GDP and real GDP follow the pace of technological change.
2. Keynesian – left alone, the economy would rarely operate at full employment, it needs the help from
government intervention (fiscal policy and monetary policy)
o Based on beliefs about the force that determine AD and SAS
o Expectations are the most significant influence on AD, based on “animal spirits”
o Money wage rate on the SAS is extremely sticky in the downward direction, it doesn’t fall
In a recession, the money wage rate cannot fall therefore the economy is stuck
New Keynesian – Money wage rate is sticky, but prices of goods and services are sticky too (price level)
With a sticky price level, the SAS is horizontal at a fixed price level
3. Monetarist – economy is self-regulating and it will normally operate at full-employment provided that monetary
policy is not erratic and the pace of money growth is kept steady.
o The quantity of money is the most significant influence on AD
o All recessions result from inappropriate monetary policy
o The money wage rate on the SAS is sticky like in the Keynesian view
o Same as the classical, the view on fiscal policy should be kept low to avoid disincentive effects that
decrease potential GDP Mathematical Note
Aggregrae planned expenditure, AE
Real GDP, Y
Consumption expenditure, C
Disposable income, YD
Government expenditure, G
Net Taxes, T
Autonomous consumption expenditure, a
Autonomous taxes, Ta
Marginal tax rate, t
Autonomous expenditure, A
Aggregate planned expenditure (AE) is the sum of the planned amounts of consumption expenditure ©, investment (I),
government expenditure (G), and exports (X) minus the planned amount of imports (M)
AE = C + I + G + X – M
Consumption expenditure (C) depends on disposable income (YD), and we write the consumption function as
C = a + bYD
Disposable income (YD) equals real GDP minus net taxes (Y – T). So if we replace YD with (Y – T), the consumption
C = a + b(Y – T)
Net taxes, T, equal autonomous taxes (that are independent of income), Ta, plus induced taxes (that vary with income),
So we can write net taxes as T = Ta + tY
Use this last equation to palce T in the consumption. The consumption function becomes
C = a – bTa + b(1 – t)Y
This equation describes consumption expenditure as a function of real GDP
Imports depend on real GDP, and the import function is
M = my
Aggregate Expenditure Curve
Use the consumption function and the import function to replace C and M in the AE equation. That is,
AE = a – bTa + b(1 – t)Y + I + + G + X – mY
Colelct the terms that involve Y on the right side of the equation to obtain
AE = (a – bTa + I + G + X) + [b(1 – t) – m]Y
Autonomous expenditure (A) is (a –bTa + I + G + X), and the slope of the AE curve is
Aggregate Expenditure Curve = Consumption function + I + G + NX CH 27 EXPENDITURE MULTIPLIERS: THE KEYNESIAN MODEL
The economy as a whole;
1. Price level is fixed
2. AD determines real GDP
The Keynesian model explains fluctuations in AD at a fixed price level by identifying the forces that determine
Aggregate expenditure has four components: C, I, G, and NX which sum to real GDP
Aggregate planned expenditure – is equal to the sum of the planned levels of C, G, I, and NX.
- Planned C and imports, change when income changes and so they depend on real GDP
A Two-Way Link between Aggregate Expenditure and Real GDP
There is a two-way link between aggregate expenditure and real GDP; Other things remaining the same
- An increase in real GDP increase aggregate expenditure
- An increase in aggregate expenditure increase real GDP
Several factors influence C and saving plans. The most important ones are
1. Disposable income – is aggregate income minus taxes plus transfer payments.
o Aggregate income equals real GDP, so disposable income depends on real GDP
o To explore the two-way link between real GDP and planned C, we focus on the relationship between C
and disposable income, when the other three factors are constant.
2. Real interest rate
4. Expected future income
Households can only spend their disposable income on consumption or save it, so planned C plus S always equals
Consumption function – relationship between C and disposable income, other things remaining the same
- An increase in disposable income increases C
- When disposable income is zero, the amount still spent is called autonomous consumption.
- C in excess of this amount is called induced consumption (C that is induced by an increase in disposable income)
- The 45° line is where disposable income equals C
Saving function – relationship between saving and disposable income, other things remaining the same
- As disposable income increases, saving increases
- When C exceed disposable income in the consumption function dissaving occurs.
- When C is below disposable income in the consumption function saving occurs.
Marginal Propensities to Consume and Save
Marginal propensity to consume (MPC) – the fraction of a change in disposable income that is spent on consumption
- It is equaled to change in C divided by change in disposable income (MPC = ΔC/ΔYD)
- Slope of consumption function
Marginal propensity to save (MPS) – the fraction of a change in disposable income that is saved
- It is equaled to change in S divided by change in disposable income (MPS = ΔS/ΔYD)
- Slope of saving function
ΔC + ΔS = ΔYD -> ΔC/ΔYD + ΔS/ΔYD = 1 -> MPC + MPS = 1
Marginal propensity to import (MPM) – the fraction of an increase in real GDP that is spent on imports
- It is equaled to the change in imports divided by the change in real GDP (MPM = ΔM/ΔY)
Real GDP with a Fixed Price Level
The aggregate expenditure curve is a graph of the aggregate expenditure schedule (relationship between aggregate
planned expenditure and real GDP)
AE curve – is a graph of aggregate planned expenditure (C is the vertical gap between I+G+X and I+G+X+C)
- To get the curve subtract imports (M) from I+G+X+C line
- Aggregate expenditure includes imports unlike aggregate planned expenditure Induced expenditure – It is equaled to C minus M, which varies with real GDP
Autonomous expenditure – It is equaled to I plus G plus X, which does not vary with real GDP (constant components)
- Consumption expenditure and imports can also have an autonomous components
- Autonomous expenditure is the level of aggregate planned expenditure if real GDP were 0.
Actual Expenditure, Planned Expenditure, and Real GDP
Actual aggregate expenditure is always equal to real GDP, but aggregate planned expenditure is not always equal to
actual aggregate expenditure and therefore not always equal to real GDP
- They differ because firms can end up with inventories that are greater or smaller than planned
- One component of planned investment is the change in firms’ inventories
o If aggregate planned expenditure is less than real GDP; firms sell less/more than they planned to sell and
end up with unplanned/low inventories
Equilibrium expenditure – level of aggregate expenditure that occurs when aggregate planned expenditure equals real
- Level at which spending plans are fulfilled
- At a given price level, equilibrium expenditure determines real GDP
- When aggregate planned expenditure and actual aggregate expenditure are unequal, a process of convergence
towards equilibrium expenditure occurs. Throughout this process real GDP adjusts
- Where the AE curves lies about the 45° line, aggregate planned expenditure exceeds real GDP; where the AE
curve leis below the 45° line, aggregate planned expenditure is less than real GDP; and where the AE curve
intersects the 45° line, aggregate planned expenditure equals real GDP.
Convergence to Equilibrium
From Below Equilibrium
- Aggregate planned expenditure exceeds actual expenditure
- Inventories fall therefore actual investment is less than planned investment
- Firms will need to increase inventories which means they hire labour to increase production
- This cycle ends when equilibrium is reached
From Above Equilibrium
- Actual expenditure exceeds aggregate planned expenditure
- Inventories rise therefore actual investment is more than planned investment
- Firms will need to decrease inventories which means they cut production to decrease inventories
- This cycle ends when equilibrium is reached
When autonomous expenditure increases, aggregate expenditure increases and so does equilibrium expenditure and
real GDP. But the increase in real GDP is larger than the change in autonomous expenditure
Multiplier – the amount by which a change in autonomous expenditure is magnified or multiplied to determine the
change in equilibrium expenditure and real GDP.
- Occurs over a period of time
- Equilibrium expenditure increases by the sum of the initial increase in autonomous expenditure and the increase
in induced expenditure (N) (initially when autonomous expenditure increase, aggregate planned expenditure
exceed real GDP which resulted in production increases along with real GDP -> induced expenditure increases)
o Multiplier is greater than 1 because induced expenditure increases; an increase in autonomous
expenditure induces further increases in expenditure.
- Multiplier = Δ Equilibrium expenditure/Δ Autonomous expenditure (A)
o = ΔY/ΔA = 1/(1-Slope of AE curve)
o = 1/(1-MPC)
o = 1/MPS
- ΔY = ΔN+ΔA -> Slope of AE = ΔN/ΔY
- ΔY = ΔA/(1-Slope of AE Curve) Imports and Income Taxes
Imports and income taxes influence the size of the multiplier and make it smaller than it otherwise would be
- An increase in investment increase real GDP -> increases consumption expenditure, but part is on imported
goods and services
- Income tax payments increase so disposable income increase by less than the increase in real GDP and
consumption expenditure by less than it would if taxes had not increased.
- MPM and income tax rate together with MPC determine the multiplier and their combined influence determines
the slope of the AE curve
Adjusting Quantities and Prices
We’ve looked at production level changes of an individual firm, but now we’ll look at when they change prices which
also changes the economy’s price level
- Therefore we look at AS-AD model and its relationship with the aggregate expenditure model specifically
aggregate expenditure and aggregate demand with its corresponding curves.
When the price level changes, aggregate planned expenditure changes and the quantity of real GDP demanded changes,
the aggregate demand curve slopes downward due to:
- Wealth effect
- Substitution effects
o Intertemporal substitution – a rise in price level today delays our purchases
o International substitution – a rise in Canadian price level results in an increase for Canadian imports and
decrease in Canadian exports
When the price level rises, each of these effects reduces aggregate planned expenditure at each level of real
GDP, shifting the aggregate expenditure curve downwards (with movement along the AD curve)
Changes in Aggregate Expenditure and Aggregate Demand
When any influence on aggregate planned expenditure other than price level changes, both the aggregate expenditure
curve and the aggregate demand curve shift
- For example, an increase in investment or exports
- The shift size of the AD curve depends on the multiplier
o Ex. Multiplier is 2, an increase in autonomous expenditure by $100 results in a rightward shift of $200
for the AD curve
Equilibrium Real GDP and the Price Level
- An increase in investment increases aggregate planned expenditure, but since the price level is not constant; it
rises, which decreases aggregate planned expenditure by a smaller amount. This also shifts the AD curve by an
amount which is dependent on the multiplier.
1. Increase in AE curve
2. Decrease in AE curve by smaller amount than increase and AD shifts by multiplier amount
- An increase in investment increases aggregate planned expenditure, but since the price level is not constant; it
rises, which decreases aggregate planned expenditure by a smaller amount. This also shifts the AD curve by an
amount which is dependent on the multiplier.
- Then, since real GDP now exceed potential GDP, shortages of labour increase the money wage rate. The higher
money wage rate increase firms’ costs, which decreases SAS and shifts it leftward up along the AD curve. The
price level raises further and real GDP decreases, there is movement along AD and the AE shifts downwards back
to its original position. The increase in money wage rate and the price level increased by the same percentage
which means that real GDP is again equaled to potential GDP. In the long run, the multiplier is zero.
1. Decrease in SAS and move leftwards up along the AD curve and AE curve returns to original position.
The new equilibrium is has moved up vertically from original position
CH 28 CANADIAN INFLATION, UNEMPLOYMENT, AND BUSINESS CYCLE Inflation Cycles
Demand-pull inflation – An inflation that starts because AD increases
- Can be kicked off by any of the factors that change aggregate demand (ex., cuts in interest rate, an increase in
the quantity of money, an increase in government expenditure, a tax cut, an increase in exports, or an increase
1. Increase in AD raises price level and increase real GDP
2. The money wage rises and SAS shifts leftward up along the AD curve. Price level rises further and
real GDP declines
Cost-push inflation – An inflation that is kicked off by an increase in costs
Two main sources of increases are
- An increase in the money wage rate
- An increase in the money prices of raw materials
1. Factor price rise shifts the SAS leftward and the price level rises
2. The Bank of Canada increase AD to restore full employment and the price level rises again
Stagflation – a combination of rising price level and decreasing real GDP
If the Bank of Canada continues responding, inflation will continue to rise, if they stop responding, the
economy remains below full-employment.
If inflation is expect, the fluctuations in real GDP that accompany demand-pull and cost-push inflation do not occur
1. AD is expected to increase
2. The money wage rate rises and SAS shifts leftward
- Equilibrium has moved up vertically
Rational expectation – the best forecast available that is based on all the relevant information, not necessarily correct
Inflation and Unemployment: The Phillips Curve
Phillips curve – relationship of the short-run tradeoff between inflation and unemployment
Short-run Phillips curve – the relationship between inflation and unemployment, holding constant,
1. The expected inflation rate (y-axis)
2. The natural unemployment (x-axis)
An unexpected increase/decrease in aggregate demand lowers/raises unemployment and increases/decreases
inflation rate (movement up/down along the curve)
Similarly, a movement along the SAS curve that brings a lower price level and a decrease in real GDP is
equivalent to a movement down along the SRPC.
Long-run Phillips curve – shows the relationship between inflation and unemployment when the actual inflation
rate equals the expected inflation rate.
Consistent with AS-AD model, which predicts, when inflation is expected, real GDP equals potential GDP and
unemployment is at its natural rate.
1. Decrease/increase in expected inflation shifts SRPC downwards/upwards
2. Increase/decrease in natural unemployment rate shifts LRPC and SRPC rightward/leftward
The Business Cycle
- Mainstream business cycle theory
o Potential GDP grows at a steady rate while aggregate demand grows at a fluctuating rate. Because the
money wage rate is sticky; if aggregate grows faster/slower than potential GDP; real GDP moves
above/below potential GDP and an inflationary/recessionary gap emerges
o Expansions occur when potential GDP (LAS shifts rightward) and AD also increases and usually by more
than potential GDP; so the price level rises.
Keynesian cycle theory – “animal spirits” are the main source of fluctuations in AD
Monetarist cycle theory – fluctuations in both investment and consumption expenditure, driven
by fluctuations in the growth rate of the quantity of money, are the main sources of fluctuations
in AD. Both Keynesian and monetarist cycle theories assume that the money wage rate is rigid
and don’t explain it
New classical cycle theory – the rational expectation of the price level, which is determined by
potential GDP and expected AD , determines the money wage rate and position of the SAS
curve. Only unexpected fluctuations in AD brings fluctuations in real GDP around potential GDP
New Keynesian cycle theory – today’s money wage rate were negotiated at many past dates,
which means that past rational expectations of the current price level influence the money wage
rate and the position of the SAS curve. Both unexpected and currently expected fluctuations in
AD brings fluctuations in real GDP around potential GDP
- Real business cycle theory
o Regards random fluctuations in productivity as the main source of economic fluctuations. These
productivity fluctuations are assumed to result mainly from fluctuations in the pace of technological
change. But they might also have other sources, such as international disturbances, climate fluctuations,
or natural disasters.
The impulse in the growth rate of productivity that results from technological change, which is
generated mainly by the process of research and development that leads to the creation and
use of new technologies
Measure the change in the combined productivity of capital and labour
RBC impulse for Canada from 1962 through 2010 you can see that fluctuations in productivity
are correlated with real GDP fluctuations
All technological change eventually increases productivity, but if initially it makes a sufficient
amount of existing capital, especially human capital, obsolete, productivity can temporarily fall.
The RBC Mechanism
Two effects follow from a change in productivity that sparks an expansion or a contraction:
1. Investment demand changes
2. The demand for labour changes
- During a recession, the initial effect of a temporary fall in productivity is a decrease in investment demand and a
decrease in the demand for labour (DLF shifts leftwards
- The decrease in the demand for labour (LD shifts leftwards) which decreases real interest rate and when-to-
work occurs (LS shifts leftwards)
o Main criticisms
1. Money wage rate is sticky and to assume otherwise is at odds with a clear fact
2. Intertemporal substitution is too weak a force to account for large fluctuations in labour supply and
employment with small real wage rate changes
3. Productivity shocks are likely to be caused by changes in aggregate demand as by technological
change -> business cycle caused fluctuations in productivity CH 29 FISCAL POLICY
The Federal Budget
Federal budget – annual statement of the outlays and revenues of the Government of Canada, together with the laws
and regulations that approve and support those outlays and revenues
Fiscal policy – the use of the federal budget to achieve macroeconomic objectives such as full employment, sustained
long-term economic growth, and price level stability.
The federal government and Parliament make fiscal policy
The process begins with long, drawn-out consultations between the Minister of Finance and Department of Finance
officials and their counterparts in the provincial governments. After all these consultations and using economic
projections made by Department of Finance economists, the Minister develops a set of proposals, which are discussed in
Cabinet and which become government policy. The Minister finally presents a budget plan to Parliament, which debates
the plan and enacts the laws necessary to implement it.
Highlights of the 2011 Budget
- Revenues are the federal government’s receipts which were projected at $249 billion
1. Personal income taxes (largest source of revenue)
2. Corporate income taxes (smallest source of revenue)
3. Indirect and other taxes
4. Investment income
1. Transfer payments (largest outlay, by a big margin)
o Includes unemployment cheques and welfare payments to individuals, farm subsidies, grants to
provincial and local governments, aids to developing countries, and dues to international organizations
2. Expenditures on goods and services
o Includes national defense, highways, government cars, etc
3. Debt interest (is the interest on the government debt)
- Budget balance (is equaled to revenues minus outlays)
o Budget surplus – revenues exceed outlays
o Budget deficit – outlays exceed revenues
o Balanced budget – revenues equal outlays
Supply-side Effects of Fiscal Policy
Economists, known as supply-siders, believe tax on personal and corporate income affects real GDP and employment to
be large and an accumulating body of evidence suggests that they are correct
- At full employment, the real wage rate adjusts to make the quantity of labour demanded equal to the quantity
of labour supplied
Tax on labour income influences potential GDP and aggregate supply by changing the full-employment quantity of
- Income tax weakens the incentive to work and drives a wedge between the take-home wage of workers and the
cost of labour to firms -> results in smaller quantity of labour and a lower potential GDP (LS shifts leftwards
becomes LS + tax)
- Workers look at the after-tax wage rate when they decide how much labour to supply
- The vertical distance between the LS curve and LS + tax curve is the income tax
Tax wedge – the gap created between the before-tax and after-tax wage rates
o An income tax of 25% and the tax rate on consumption expenditure is 10%, a dollar earned buys only 65
cents worth of goods and services -> tax wedge is 35%
- A tax on interest income weakens the incentive to save and drives a wedge between the after-tax interest rate
earned by savers and the interest rate paid by firms. These effects are analogous to tax on labour income for
two reasons 1. A tax on labour income lowers the quantity of labour employed and lowers potential GDP, while a
tax on capital income lowers the quantity of saving and investment and slows the growth of real
2. The true tax rate on interest income is much higher than on labour income because of the way in
which inflation and taxes on interest income interact
o The interest rate that influences investment and saving plan is the real after-tax interest rate
o Real after-tax interest rate subtracts the income tax paid on interest income from the real interest rate
But taxes depend on the nominal interest rate, not the real interest rate. So the higher the
inflation rate, the higher is the true tax rate on interest income
Ex. Real interest rate is 4% a year and tax rate is 40%, if there is no inflation, the nominal
interest rate equals the real interest rate. The tax on 4% interest is 1.6% (40% of 4%) so
the real after-tax interest rate is 4% - 1.6% = 2.4%
Ex2. Inflation rate is 6% a year and the nominal interest rate is 10%. The tax on 10% is
4% (40% of 10%), so the real after-tax interest rate is 4% - 4% = 0. The true tax rate in
this case is not 40% but 100%
A tax on interest income has no effect on the demand for loanable funds (investment), but the
quantity of investment and borrowing that firms plan to undertake depends on how productive
capital is and what it costs – its real interest rate.
A tax on interest income weakens the incentive to save and lend and decreases the supply of
loanable funds (savings) -> SLF shifts leftwards and is now the SLF + tax
The vertical distance between SLF and SLF + tax is the amount of tax
A tax wedge is driven between the interest rate and the after-tax interest rate
Savings and investment decrease
Tax Revenues and the Laffer Curve
A higher tax rate does not always bring greater tax