Chapter 17 Fiscal policy and foreign trade ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 Some key terms Fiscal policy the government’s decisions about spending and taxes Stabilisation policy government actions to try to keep output close to its potential level Budget deficit the excess of government outlays over government receipts National debt the stock of outstanding government debt ©McGraw-Hill Companies, 2010 2

Government in the income-expenditure model Direct taxes affect the slope of the consumption function and hence the slope of the AD schedule. Government expenditure affects the position of the AD schedule. ©McGraw-Hill Companies, 2010 3

©McGraw-Hill Companies, 2010 Fiscal policy AD1 This seems to suggest that the government could influence aggregate output in the economy by raising AD from AD0 to AD1, 45o line Aggregate demand AD0 Y1 thus raising equilibrium output from Y0 to Y1. But this ignores some important issues – prices, interest rates, and the need to fund the government spending. Y0 Income, output ©McGraw-Hill Companies, 2010 4

©McGraw-Hill Companies, 2010 The government budget The budget deficit = total government spending, minus total tax revenue. If government spending is independent of income, G G, NT but net taxes depend on income, NT Y0 The balanced budget multiplier states that an increase in government spending plus an equal increase in taxes leads to higher equilibrium output. Balanced budget then the budget will be in deficit at low levels of income but in surplus at high levels. Income, output ©McGraw-Hill Companies, 2010 5

Deficits and the fiscal stance The size of the budget deficit is not a good measure of the government’s fiscal stance. The structural budget shows what the budget would have been if output had been at the full-employment level. The inflation-adjusted budget uses real not nominal interest rates to calculate government spending on debt interest. ©McGraw-Hill Companies, 2010 6

Automatic stabilisers mechanisms in the economy that reduce the response of GNP to shocks for example, in a recession: payments of unemployment benefits rise and receipts from VAT and income tax fall ©McGraw-Hill Companies, 2010 7

Limits on active fiscal policy Why can’t shocks to aggregate demand immediately be offset by fiscal policy? Time lags: it takes time to diagnose the problem to take action for the multiplier process to operate Uncertainty the size of the multiplier is not known aggregate demand is always changing Induced effects on autonomous demand changes in fiscal policy may induce offsetting effects in other components of aggregate demand ©McGraw-Hill Companies, 2010 8

Limits on active fiscal policy (2) Why doesn’t the government expand fiscal policy when unemployment is persistently high? The budget deficit concern about inflation if the budget deficit grows Maybe we’re at full employment! unemployment may be (at least partly) voluntary ©McGraw-Hill Companies, 2010 9

Foreign trade and income determination Introducing exports (X) & imports (Z) Trade Balance the value of net exports (X - Z) Trade Deficit when imports exceed exports Trade Surplus when exports exceed imports Equilibrium is now where Y = C + I + G + X - Z ©McGraw-Hill Companies, 2010 10

Exports, imports & the trade balance Assume that exports are independent of income, Exports but that imports increase with income. Imports X, Z At higher income levels, there is a trade deficit. At relatively low income, exports exceed imports – there is a trade surplus. There is trade balance at income Y*, but there is no guarantee that this corresponds to full employment. Y* Income ©McGraw-Hill Companies, 2010 11

Foreign trade and the multiplier The marginal propensity to import is the fraction of additional income that domestic residents wish to spend on additional imports. The effect of foreign trade is to reduce the size of the multiplier the higher the value of the marginal propensity to import, the lower the value of the multiplier. ©McGraw-Hill Companies, 2010 12

Some maths: The multiplier Equilibrium is where: Y* = C + I + G + X – Z where C = A + c(1-t)Y and Z = zY. c = marginal propensity to consumer; t = the tax rate and z the marginal propensity to import. Hence: Y* = [A + G + X + I] + c(1-t)Y – zY Equilibrium dictates Y*=Y and hence: Y* = [A + I + G + X ]/[ 1 – c(1-t) + z ] ©McGraw-Hill Companies, 2010 13

Y* = [A + I + G + X ]/[ 1 – c(1-t) + z ] Equilibrium output is the product of autonomous spending - autonomous consumption demand A, plus injections from investment, government spending, and exports and the multiplier {1 / [ 1 – c(1-t) + z ]} In a small open economy, the marginal propensity to import z will be much higher than in a large closed economy such as the United States. Hence the multiplier will be lower in Belgium than in the USA. ©McGraw-Hill Companies, 2010 14