Macroeconomics (ECON 1211) Lecturer: Dr B. M Macroeconomics (ECON 1211) Lecturer: Dr B. M. Nowbutsing Topic: Aggregate demand, fiscal policy, and foreign trade

Some Key Terms Fiscal policy Stabilization policy Budget deficit the government’s decisions about spending and taxes Stabilization 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 See the introduction to Chapter 22 in the main text.

The Government and the Circular Flow Introduction of Government: Another Agent AD = C + I + G (assumed that G is autonomous) YD = Y – NT If NT = tY (0<t<1); YD = Y (1- t) C = f (YD), slope of consumption function is lower with taxes. If autonomous consumption is zero and MPC = 0.8. Then C = 0.8 YD = 0.8 (1 – t) Y If tax rate = 0.2, then C = 0.64 Y This implies MPCT = MPC (1 – t)

3. 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

4. A Higher Net Tax Rate AD0 AD1 Y1 Y0 An increase in tax rate shift the consumption function which in turn shift the AD curve Aggregate demand AD0 Income, output 45o line Y1 AD1 Y0 thus drecreasing equilibrium output from Y0 to Y1.

5. Government Spending AD1 AD0 Y0 Y1 Assume tax rate is zero, And government spending Increases. With a MPC of 0.9, the multiplier is 10 Income, output Aggregate demand 45o line AD0 Y0 AD1 Y1 A rise in government expenditure G induce a rise in output by ten times that amount

6. The Balanced Budget Multiplier According to the balanced budget multiplier, an increase in G accompanied by an increase in NT, has an expansionary effect on output This is because AD increase by the full amount of an increase in G but AD does not fall by the full amount in taxes as C falls by less If G and T rises by 200, Then AD rises by 200, YD fall by 200 Assuming MPC = 0.75, AD should fall by 150 Ultimately, there is a net increase in AD of 50

7. The Government Budget The budget deficit equals total government spending minus total tax revenue; BD = G -NT If government spending is independent of income G G, NT but net taxes depend on income, As noted, the balanced budget multiplier states that an increase in government spending plus an equal increase in taxes leads to higher equilibrium output. Balanced budget but in surplus at high levels then the budget will be in deficit at low levels of income Income, output

8. Investment, Saving and Budget Without government, planned savings equal to planned investment With govt. in equilibrium, planned savings equal planned injections, S + NT = G + I This implies S – I = G – NT Thus, private sector surplus (S > I) must be matched by a government budget deficit (G > NT)

9. Deficits and the Fiscal Stance The size of the budget deficit is not a good measure of the government’s fiscal stance for the following reasons BD can change for reasons other than fiscal policy, e.g. If I falls, Y falls as well as T For given level of T and G, BD is higher in recession than in boom Official measures of the deficit treat the whole of the nominal interest paid by the government on the national debt as an item of G

10. Deficits and the 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.

11. Automatic Stabilizers & Discretionary Fiscal Policy Automatic Stabilizers are 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 Discretionary fiscal policy is decisions about tax rate and levels of government spending

12. 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

12. 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

13. Foreign Trade and Income Determination Introducing exports (X) & imports (Z) It affects AD and multiplier 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

14. Exports, Imports and 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

15. Foreign Trade and the Multiplier K = 1 / 1 – (MPCT – MPZ) = 1 / 1 – MPCT + MPZ) 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.

16. Investment, Savings, the Budget Deficit and Trade Deficit In equilibrium total injections = total withdrawals S + NT + Z = I + G + X S – I = (G – NT) + (X – Z) Thus, S – I = Budget deficit/Surplus + Trade Deficit/Surplus