THE GOVERNMENT AND FISCAL POLICY Chapter 21 1. THE GOVERNMENT AND FISCAL POLICY Government can...

The Governmentand

Fiscal PolicyChapter 21

1

THE GOVERNMENT AND FISCAL POLICYGovernment can affect the macroeconomy through two policy channels:

• fiscal policy The government’s spending and taxing policies• Fisc referring to the treasury of a government

• monetary policy The behavior of the Central Bank concerning the nation’s money supply

2

THE GOVERNMENT AND FISCAL POLICYFiscal policy:

• Policies concerning government purchases of goods and services

• Policies concerning taxes• Policies concerning transfer payments (such as social

security benefits)

3

GOVERNMENT IN THE ECONOMYdiscretionary fiscal policy Changes in taxes or spending that are the result of deliberate changes in government policy

4

GOVERNMENT IN THE ECONOMYGOVERNMENT PURCHASES (G), NET TAXES (T), AND

DISPOSABLE INCOME (YD)

net taxes (T) Taxes paid by firms and households to the government minus transfer payments made to households by the government

5

GOVERNMENT IN THE ECONOMY

FIGURE 9.1 Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income

6

GOVERNMENT IN THE ECONOMYdisposable, or after-tax, income (Yd) Total income minus net taxes: Y − T

disposable income ≡ total income − net taxes

Yd ≡ Y − T

7

GOVERNMENT IN THE ECONOMY• The disposable income (Yd) of households must end up as either consumption or saving (S)

Yd≡C+S• As disposable income is aggregate income (Y) minus taxes (T)

Y-T≡C+SY≡C+S+T

8

GOVERNMENT IN THE ECONOMY• When government enters the picture, the aggregate

income identity gets cut into three pieces:• Government takes a part (net taxes T)• Households divide the rest between consumption (C)

and saving (S)

• Planned aggregate expenditure (AE) is the sum of consumption spending by households (C), investment by business firms (I) and government purchases of goods and services (G)

AE≡C+I+G

9

GOVERNMENT IN THE ECONOMYbudget deficit The difference between what a government spends and what it collects in taxes in a given period: G − T

budget deficit ≡ G − T

• If G>T government must borrow from the public to finance the deficit

• If G<T government is spending less than it is collecting in taxes, the government is running a surplus

10


Adding Taxes to the Consumption Function• To modify our aggregate consumption function to incorporate

disposable income instead of before-tax income, instead of C = a + bY, we write

C = a + bYd

C = a + b(Y − T)

• Our consumption function now has consumption depending on disposable income instead of before-tax income

11

GOVERNMENT IN THE ECONOMYInvestment

The government can affect investment behavior through its tax treatment of depreciation and other tax policies

• For our present purposes, we continue to assume that planned investment (I) is autonomous

12


EQUILIBRIUM OUTPUT: Y = C + I + G

13

Output ↓+ 1501,3501001002501,1501,4001001,500

Output ↓+ 1001,2001001002001,0001,2001001,300

Output ↓+ 501,0501001001508501,0001001,100

Equilibrium0900100100100700800100900Output ↑ 5075010010050550600100700Output ↑ 1006001001000400400100500Output ↑ 150450100100 50250200100300

ADJUSTMENTTO

DISEQUILIBRIUM

UNPLANNEDINVENTORY

CHANGEY (C + I + G)

PLANNEDAGGREGATE

EXPENDITUREC + I + G

GOVERNMENTPURCHASES

G

PLANNEDINVESTMENT

SPENDINGI

SAVINGS

(Yd – C)

CONSUMPTIONSPENDING

(C = 100 + .75 Yd)

DISPOSABLEINCOMEYd ≡Y T

NETTAXES

T

OUTPUT(INCOME)

Y

(10)(9)(8)(7)(6)(5)(4)(3)(2)(1)

TABLE 9.1 Finding Equilibrium for I = 100, G = 100, and T = 100(All Figures in Billions of Dollars)

Output ↓+ 1501,3501001002501,1501,4001001,500

Output ↓+ 1001,2001001002001,0001,2001001,300

Output ↓+ 501,0501001001508501,0001001,100

Equilibrium0900100100100700800100900Output ↑ 5075010010050550600100700Output ↑ 1006001001000400400100500Output ↑ 150450100100 50250200100300

ADJUSTMENTTO

DISEQUILIBRIUM

UNPLANNEDINVENTORY

CHANGEY (C + I + G)

PLANNEDAGGREGATE


GOVERNMENTPURCHASES

G

PLANNEDINVESTMENT

SPENDINGI

SAVINGS

(Yd – C)

CONSUMPTIONSPENDING

(C = 100 + .75 Yd)


NETTAXES

T

OUTPUT(INCOME)

Y

(10)(9)(8)(7)(6)(5)(4)(3)(2)(1)

TABLE 9.1 Finding Equilibrium for I = 100, G = 100, and T = 100(All Figures in Billions of Dollars)

GOVERNMENT IN THE ECONOMYequilibrium condition: Y = C + I + G

• If Y>AE=C+I+G unplanned increase in inventories• If Y< C+I+G unplanned decrease in inventories

An example: C=100+0.75Yd

• Introduce government sectorC=100+0.75(Y-T)

• Government purchases G=100• Net taxes T=100• Government is running a balanced budget that is

financing all of its spending with taxes• Planned investment I=100

14


FIGURE 9.2 Finding Equilibrium Output/Income Graphically

15

GOVERNMENT IN THE ECONOMYThe Leakages/Injections Approach to Equilibrium• Aggregate income flows into households and consumption and

saving flow out

• Saving flowing from households into the financial market is used by firms to finance their investment projects

• If planned investment of firms equals the saving of households, then planned aggregate expenditure (AE=C+I) equals aggregate output (income) (Y) and there is equilibrium

• The leakage out of the spending stream (saving) is matched by an equal injection of planned investment spending into the spending stream

16

GOVERNMENT IN THE ECONOMY• Taxes (T) are a leakage from the flow of income • Saving (S) is also a leakage

• In equilibrium, aggregate output (income) (Y) equals planned aggregate expenditure (AE), and leakages (S + T) must equal planned injections (I + G) Algebraically,

AE=C+I+GY=C+S+T

• At equilibrium Y=AEC+S+T=C+I+G

S+T=I+G• leakages/injections approach to equilibrium: S + T = I + G

17

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS• Assume that Y=900 YTL, G=100 YTL, T=100 YTL, I=100 YTL

• As a policy maker you want to increase output and income to 1100 YTL

• How can the government use taxing and spending policy (fiscal policy) to increase the equilibrium level of output?

• Not possible to increase taxes• Change government spending G

18

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS• How much of an increase in spending would be required

to generate a 200 YTL increase in the equilibrium level of output?

• Answer → because we need to increase income by 200 YTL, we should increase government spending by the same amount (wrong)

Increase in G → AE increases by 200 YTL → AE>Y inventories will be lower than planned → firms will have incentive to increase output → more to the story than this

19

FISCAL POLICY AT WORK: MULTIPLIER EFFECTSAs Y rises → the economy is generating more income

→ creation of more employment → newly employed workers increase

consumption spending→ planned spending will be higher than output (AE>Y)→ inventories will be lower than planned→ firms will raise output→ thus raise income again Familiar multiplier in action

20

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS

21

Output ↓+ 501,2501501002001,0001,2001001,300

Equilibrium01,1001501001508501,0001001,100

Output ↑ 50950150100100700800100900

Output ↑ 10080015010050550600100700

Output ↑ 1506501501000400400100500

Output ↑ 200500150100 50250200100300

ADJUSTMENTTO

DISEQUILIBRIUM

UNPLANNEDINVENTORY

CHANGEY (C + I + G)

PLANNEDAGGREGATE


GOVERNMENTPURCHASES

G

PLANNEDINVESTMENT

SPENDINGI

SAVINGS

(Yd – C)

CONSUMPTIONSPENDING

(C = 100 + .75 Yd)

DISPOSABLEINCOME

Yd ≡ Y T

NETTAXES

T

OUTPUT(INCOME)

Y

(10)(9)(8)(7)(6)(5)(4)(3)(2)(1)

TABLE 9.2 Finding Equilibrium After a $50 Billion Government Spending Increase (All Figures in Billions of Dollars; G Has Increased from 100 in Table 9.1 to 150 Here)

Output ↓+ 501,2501501002001,0001,2001001,300

Equilibrium01,1001501001508501,0001001,100

Output ↑ 50950150100100700800100900

Output ↑ 10080015010050550600100700

Output ↑ 1506501501000400400100500

Output ↑ 200500150100 50250200100300

ADJUSTMENTTO

DISEQUILIBRIUM

UNPLANNEDINVENTORY

CHANGEY (C + I + G)

PLANNEDAGGREGATE


GOVERNMENTPURCHASES

G

PLANNEDINVESTMENT

SPENDINGI

SAVINGS

(Yd – C)

CONSUMPTIONSPENDING

(C = 100 + .75 Yd)

DISPOSABLEINCOME

Yd ≡ Y T

NETTAXES

T

OUTPUT(INCOME)

Y

(10)(9)(8)(7)(6)(5)(4)(3)(2)(1)

TABLE 9.2 Finding Equilibrium After a $50 Billion Government Spending Increase (All Figures in Billions of Dollars; G Has Increased from 100 in Table 9.1 to 150 Here)


THE GOVERNMENT SPENDING MULTIPLIER

government spending multiplier The ratio of the change in the equilibrium level of output to a change in government spending

Government spending multiplier≡1/MPS

• An increase in government spending has the same impact on the equilibrium level of output and income as an increase in planned investment

22


FIGURE 9.3 The Government Spending Multiplier

23

DERIVING THE GOVERNMENT SPENDING MULTIPLIER ALGEBRAICALLY

Recall that our consumption function is:

C = a + b(Y-T)

where b is the marginal propensity to consume. In equilibrium:

Y = C + I+G

Now we solve these two equations for Y in terms of I. By substituting the first equation into the second,

we get:

24


Y =a + b(Y –T)+ I+G

Y =a + Y –bT+ I+G

Y-bY=a+I+G-bT

Y(1-b)=a+I+G-bT

We can then solve for Y in terms of I by dividing through by (1 − b):

25

1( )

(1 )Y a I G bT

b


The multiplier is

26

MPC1

1


THE TAX MULTIPLIER

• Remember that fiscal policy comprises policies concerning government spending and policies concerning taxation

• The effect of a change in tax policy on the economy?

• The multiplier for a change in taxes is not the same as the multiplier for a change in government spending

27

FISCAL POLICY AT WORK: MULTIPLIER EFFECTSPrevious problem revised

• As a policy maker you want to increase output

• How can the government use taxing and spending policy (fiscal policy) to increase the equilibrium level of output?

• This time you do not want to increase government spending (G)

• Change taxation policy

28

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS• Decide to cut taxes and maintain the current level of

government spending• A tax cut increases disposable income• This increased income leads to increased consumption

• The question → Would decrease in taxes affect aggregate output (income) the same as an increase in government

spending (G)?

29

FISCAL POLICY AT WORK: MULTIPLIER EFFECTSA decrease in taxes → increase income

Households → higher disposable income → increase consumption→ Planned aggregate expenditure increases (AE>Y)→ Inventories will be lower than planned → A rise in output

As Y rises → creation of more employment→ more income will be generated→ causing a second-round increase in

consumption

Familiar multiplier in action

30

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS• Why does the tax multiplier differ from the spending

multiplier?

• When government increases spending, there is an immediate and direct impact on the economy’s total spending

• When taxes are cut, there is no direct impact on spending• Taxes enter picture only because they have an effect on the

household’s disposable income, which influences household’s consumption (that is a part of AE)

• The tax cut flows through households before affecting AE

31

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS• Assume the government decides to cut taxes by 1 TL

• When government spending increase by 1 TL, AE increases initially by the full amount of the rise in G

• When taxes are cut, the initial increase in AE is only the MPC times the change in taxes (due to affecting disposable income)

• As the initial increase in AE is smaller for a tax cut than for a government spending increase, the final affect on the equilibrium level of income will be smaller

32

FISCAL POLICY AT WORK: MULTIPLIER EFFECTStax multiplier The ratio of change in the equilibrium level of output to a change in taxes

•The final change in the equilibrium level of output (income) (Y)

•∆Y=(∆AE)x(1/MPS)

•The initial change in aggregate expenditure caused by a tax change of ∆T → (-∆TxMPC)

33

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS• ∆Y=(∆AE)x(1/MPS)

• ∆Y=(-∆TxMPC)x(1/MPS)

• Tax multiplier → -(MPC/MPS)

• A tax cut will cause an increase in consumption and output, so tax multiplier is negative

34

DERIVING THE TAX MULTIPLIER ALGEBRAICALLY

Y = C + I+G

Y =a + b(Y –T)+ I+G

Y-bY=a+I+G-bT

Y(1-b)=a+I+G-bT

We can then solve for Y in terms of I by dividing through by (1 − b):

35

1

1

1 1

Y a I G bTb

b MPC MPCmultiplier

b MPC MPS


THE BALANCED-BUDGET MULTIPLIER

• What if government spending and taxes are increased by the same amount?

• The government decides to pay for its extra spending by increasing taxes by the same amount

• The government’s budget deficit would not change because ∆G=∆T

36

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS• What is the effect on equilibrium income of equal increases in government spending and taxes?

• If government spending increase by 40 TL (MPC=0.75), with taxes (T) held constant, should increase the equilibrium level of income by

• ∆Y=(∆G) x government spending multiplier• ∆Y=(∆G)x(1/MPS)• ∆Y=(40)x(1/0.25)=(40x4)=160

37

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS• Now suppose that instead of keeping tax revenues constant, we finance the 40 increase in G with an equal increase in T, so as to maintain a balanced budget

• What happens to AE as a result of both the rise in G and the rise in T?

• Two initial effects• G increases by 40 (direct and positive effect)• T increases by 40 (negative effect on overall spending)

38

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS• The final effect of T increase on AE depends on how

households respond to it

• MPC=0.75 and MPS=0.25

• When disposable income falls, both C and S are reduced

• A tax (T) increase of 40 → reduces disposable income by 40 → consumption falls by 40xMPC

• As MPC=0.75, ∆C=40xMPC=30

• The net result is increase in G → ∆G=40, decrease in C → ∆C=30 → AE increases ∆AE=10

39

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS• A balanced-budget increase in G and T will raise output but by how much?

balanced-budget multiplier The ratio of change in the equilibrium level of output to a change in government spending where the change in government spending is balanced by a change in taxes so as not to create any deficit

• The balanced-budget multiplier is equal to 1: The change in Y resulting from the change in G and the equal change in T is exactly the same size as the initial change in G or T itself

40

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS• Combine the tax multiplier and the government spending multiplier

• The final effect of a simultaneous increase in G and increase in T, add the multiplier effects of the two

• Government spending multiplier = 1/MPS• Tax multiplier = -MPC/MPS• Their sum (1/MPS)+(-MPC/MPS) = (1-MPC)/MPS = MPS/MPS =1

41

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS• So, a 40 increase in G would increase equilibrium output by 160 [40 x government spending multiplier = 40x(1/MPS)=40x(1/0.25)]

• A 40 tax increase will reduce the equilibrium level of output by 120 [40 x tax multiplier = 40x(MPC/MPS)=40x(0.75/0.25)]

• The net effect= 160-120=40• The net effect on equilibrium level of Y resulting from the change in G and the change in T is exactly the size of the initial change in G or T itself

42

FISCAL POLICY AT WORK: MULTIPLIER EFFECTSPrevious problem revised again• Assume that Y=900 TL, G=100 TL, T=100 TL, I=100 TL

• As a policy maker you want to increase output and income to 1100 TL

• How can the government use taxing and spending policy (fiscal policy) to increase the equilibrium level of output without increasing the deficit?• Simultaneous increase in G and T of 200 would increase

output by 200

43


Output ↓+ 1001,4003001001,0001,2003001,500

Output ↓+ 501,2503001008501,0003001,300

Equilibrium01,1003001007008003001,100

Output ↑ 50950300100550600300900

Output ↑ 100800300100400400300700

Output ↑ 150650300100250200300500

ADJUSTMENTTO

DISEQUILIBRIUM

UNPLANNEDINVENTORY

CHANGEY (C + I + G)

PLANNEDAGGREGATE


GOVERNMENTPURCHASES

G

PLANNEDINVESTMENT

SPENDINGI

CONSUMPTIONSPENDING

(C = 100 + .75 Yd)


NETTAXES

T

OUTPUT(INCOME)

Y

(9)(8)(7)(6)(5)(4)(3)(2)(1)

TABLE 9.3 Finding Equilibrium After a $200-Billion Balanced-Budget Increase in G and T (All Figures in Billions of Dollars; Both G and T Have Increased from 100 in Table 9.1 to 300 Here)

Output ↓+ 1001,4003001001,0001,2003001,500

Output ↓+ 501,2503001008501,0003001,300

Equilibrium01,1003001007008003001,100

Output ↑ 50950300100550600300900

Output ↑ 100800300100400400300700

Output ↑ 150650300100250200300500

ADJUSTMENTTO

DISEQUILIBRIUM

UNPLANNEDINVENTORY

CHANGEY (C + I + G)

PLANNEDAGGREGATE


GOVERNMENTPURCHASES

G

PLANNEDINVESTMENT

SPENDINGI

CONSUMPTIONSPENDING

(C = 100 + .75 Yd)


NETTAXES

T

OUTPUT(INCOME)

Y

(9)(8)(7)(6)(5)(4)(3)(2)(1)

TABLE 9.3 Finding Equilibrium After a $200-Billion Balanced-Budget Increase in G and T (All Figures in Billions of Dollars; Both G and T Have Increased from 100 in Table 9.1 to 300 Here)

44

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS• An increase in government spending has a direct initial

effect on planned aggregate expenditure; a tax increase does not

• The initial effect of the tax increase is that households cut consumption by the MPC times the change in taxes

• This change in consumption is less than the change in taxes, because the MPC is less than 1

• The positive stimulus from the government spending increase is thus greater than the negative stimulus from the tax increase

• The net effect is that the balanced-budget multiplier is 1

45


Summary of Fiscal Policy Multipliers

Policy Stimulus Multiplier Final Impact on

Equilibrium Y

Government

spending multiplier

Increase or decrease in the level

of government spending : ∆G

1

MPS

1G

MPS

Tax multiplier Increase or decrease in the level

of net taxes: ∆T

MPC

MPS

MPCT

MPS

Balanced-budget

multiplier

Simultaneous balanced-budget

increase or decrease in the level

of government spending and net

taxes: ∆G=∆T

1 ∆G

46

DERIVING THE BALANCED-BUDGET MULTIPLIER ALGEBRAICALLY

• When T and G increase simultaneously, two effects on AE:

• Increase in G (∆G)• Decrease in consumption (∆C) caused by T increase → ∆C = ∆T(MPC)

• Net increase in AE = increase in AE -decrease in AE

• ∆G - ∆C [= ∆T(MPC)] = ∆G - ∆T(MPC)

47

DERIVING THE BALANCED-BUDGET MULTIPLIER ALGEBRAICALLY

• In a balanced-budget increase ∆G=∆T• Net increase in AE = ∆G - ∆T(MPC)

= ∆G - ∆G(MPC) = ∆G(1-MPC)• As 1-MPC = MPS• Net increase in AE = ∆G(MPS)• As ∆Y = ∆AE x spending multiplier (1/MPS)• ∆Y = ∆G(MPS)x(1/MPS) = ∆G

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THE GOVERNMENT AND FISCAL POLICY Chapter 21 1. THE GOVERNMENT AND FISCAL POLICY Government can...

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