MACROECONOMICS BY CURTIS, IRVINE, AND BEGG SECOND CANADIAN EDITION MCGRAW-HILL RYERSON, © 2010 Chapter 7 Government, Fiscal Policy & Real GDP

Learning Outcomes ©2010 McGraw-Hill Ryerson Ltd. Chapter 7 2 This chapter explains: The government sector of Canadian economy The government sector in the circular flow How taxes & government expenditure affect Y e The government’s budget function & budget balance Fiscal policy, the government’s budget function & balance Automatic stabilizers and discretionary fiscal policy The public debt and the government’s budget balance Government, aggregate demand, and equilibrium output

Government Outlays in Canada 2007 ©2010 McGraw-Hill Ryerson Ltd. Chapter Government in Canada = federal, provincial, municipal & hospital.

The General Govt Sector in G7 Countries 2006 ©2010 McGraw-Hill Ryerson Ltd. Chapter Canada’s budget surplus and debt ratio were unique in G7 in Recession & fiscal stimulus  budget deficits in

Government and the Circular Flow ©2010 McGraw-Hill Ryerson Ltd. Chapter G is an autonomous component of AE Taxes minus transfers = Net taxes NT, NT = tY t ≡ net tax rate = ∆NT/∆Y Taxes  YD ≡ Y – NT  ∆C component of AE The Govt budget balance BB = NT - G, BB = tY – G  Federal Government Budget 2007

The Federal Govt Budget: Canada 2007 ©2010 McGraw-Hill Ryerson Ltd. Chapter 7.2 6

Govt Expenditure, Net Taxes & Y e ©2010 McGraw-Hill Ryerson Ltd. Chapter Govt expenditure G = G 0 is an autonomous part of AE Then A 0 = C 0 + I 0 + G 0 + X 0 – Z 0 NT = tY Net tax, NT = tY, ∆NT induced by ∆Y  ∆slope AE  ∆multiplier ∆Y/∆A

Net Taxes & Consumption ©2010 McGraw-Hill Ryerson Ltd. Chapter Net Taxes(NT = tY) reduce YD at every Y YD = Y – NT = Y - tY Then C = C 0 + cYD  C = C 0 + c(Y – tY)  C = C 0 + c(1 – t)Y C is lower at every Y when t > 0 ∆t  ∆C at every Y, ∆C/∆t < 0

Net Taxes & Consumption ©2010 McGraw-Hill Ryerson Ltd. Chapter A Numerical example: ∆C/∆t < 0 Assume: NT = tY = 0.15Y,  YD = Y – NT = Y – 0.15Y Then: C = YD C = (Y – 0.15)Y C = Y Now ∆C/∆Y = 0.68: Slope of C function = 0.68

Net Taxes & Consumption ©2010 McGraw-Hill Ryerson Ltd. Chapter C Y C = Y, t = 0 C = Y, t = ΔC/ΔY = MPC(1-t) = 0.8 x 0.85 = 0.68 ∆C = 0.8(tY) = 0.8(0.15 x 300) = 36 Taxes ∆C at every Y by – ctY

The Effect of Taxes and Government Spending on Equilibrium Income ©2010 McGraw-Hill Ryerson Ltd. Chapter

Government Expenditure, Taxes, and Equilibrium Output ©2010 McGraw-Hill Ryerson Ltd. Chapter AE’ = Y AE = Y Y = AE Y AE ∆G=25 ∆Y = 62.5 ∆G = 25  ∆A = 25  ∆Y = (1/(1-0.6) = 62.5 NT = 0, ∆G is ∆A  ∆Y = ∆A x multiplier 45 0

Government Expenditure, Taxes, and Equilibrium Output ©2010 McGraw-Hill Ryerson Ltd. Chapter o AE’ = Y Y = AE Adding NT = tY to finance G AE’’ = Y Y AE 45 0 ∆t =0.125 ∆Y ∆t  ∆YD  ∆C  (∆AE/∆Y) ≡ ∆ slope of AE  ∆Multiplier  ∆Y e

The Multiplier Revisited ©2010 McGraw-Hill Ryerson Ltd. Chapter z & t reduce the slope of AE Lower AE slopes  smaller Multipliers

The Govt Budget and Budget Balance ©2010 McGraw-Hill Ryerson Ltd. Chapter Government revenue & spending: Net tax revenue: NT = tY Expenditure on goods & services: G Govt budget balance: BB = revenue - expenditure BB = tY – G

Determinants of Govt Budget Balance BB ©2010 McGraw-Hill Ryerson Ltd. Chapter The BB depends on: 1. Net tax rate (t) set by govt 2. Expenditure (G) set by the govt 3. GDP (Y) determined by AE and AD

The Govt’s Budget & Budget Balance ©2010 McGraw-Hill Ryerson Ltd. Chapter G, NT NT = t 0 Y = 0.2Y G 0 = Balanced G 0 & t 0 set by govt Budget Plan Then BB determined by Y, ∆Y  ∆BB Y Deficit 600 Surplus

The Govt’s Budget Function ©2010 McGraw-Hill Ryerson Ltd. Chapter The Govt’s Fiscal Plan sets t 0 & G 0 : NT = t 0 Y, G = G 0 Budget Function: BB 0 = t 0 Y - G 0 E.g. if BB 0 = 0.2Y – 200 ∆BB/∆Y > 0 Y NT G BB

The Govt’s Budget Function ©2010 McGraw-Hill Ryerson Ltd. Chapter BB BB 0 = 0.2Y Y This fiscal program sets t = 0.2 & G = 200 The BB depends on Y: ∆BB/∆Y > 0 A Govt Budget Function: BB 0 = 0.2Y - 200

Fiscal Policy & Govt Budget Balance ©2010 McGraw-Hill Ryerson Ltd. Chapter Fiscal policy objectives: Stabilize equilibrium Y at Y P &/or, Manage budget deficits & public debt Fiscal policy instruments: Set net tax rate (t), both taxes & transfers Set government expenditure (G) ∆ Fiscal Policy ≡ ∆Fiscal Plan  ∆BB function

Expansionary Fiscal Policy ©2010 McGraw-Hill Ryerson Ltd. Chapter Y AE 0 o AE 1 ΔG > 0 YPYP YPYP 45 0 Y0Y0 ∆Y AE A0A0 A 0 + ∆G (Y 0 – Y P ) = Recessionary Gap ∆Y = ∆G x multiplier Y = AE ∆G > 0  ↓ Recessionary Gap

Restrictive Fiscal Policy ©2010 McGraw-Hill Ryerson Ltd. Chapter AE 2 o AE 3 Y p Y 2 Y Δt > 0 ∆t > 0 to ↓ Inflationary Gap 45 0 YPYP A0A0 AE ∆Y < 0 (Y 2 – Y P ) > 0 Inflationary gap ∆t > 0  ↓ multiplier  ↓ Y e  Y P

The Structural Budget Balance ©2010 McGraw-Hill Ryerson Ltd. Chapter Indicators of Fiscal Policy Stance Actual BB: an ambiguous fiscal indicator Actual BB: an ambiguous fiscal indicator  ∆Y &/or ∆Fiscal program  ∆ BB Structural budget balance (SBB) ≡ Structural budget balance (SBB) ≡ BB Y P  SBB = t 0 Y P – G 0 ∆Fiscal program (∆t 0 &/or ∆G 0 )  ∆SBB ∆SBB  shift BB function ≡ ∆Fiscal Policy Stance

Actual & Structural Budget Balances ©2010 McGraw-Hill Ryerson Ltd. Chapter BB 0 = t 0 Y – G 0 0 -BB 1 -G 0 YpYp +BB 2 SBB 0 Y2Y2 Y1Y1 B A C BB > 0 BB < 0 BB 0 = t 0 Y – G 0 SBB 0 = t 0 Y P – G 0 Y – BB + BB ∆BB/∆Y > 0 ∆SBB/∆Y = 0

Automatic & Discretionary Fiscal Policy ©2010 McGraw-Hill Ryerson Ltd. Chapter Automatic fiscal stabilizers  Reduce slope of AE  reduce ∆Y/∆A (the multiplier)  NT = tY  (∆AE/∆Y) = [(1 – t)(c – z)]  Built into budget program by setting t in NT = tY   ∆BB moves along BB function with ∆Y Discretionary fiscal policies  ∆t &/or ∆G  shift BB function  ∆SBB  Shift AE & AD functions & ∆slopes  AE  ∆Y

Automatic and Discretionary Fiscal Policy ©2010 McGraw-Hill Ryerson Ltd. Chapter BB 0 = t 0 Y – G 0 0 BB 1 -G 0 YpYp BB 2 SBB 0 Y2Y2 Y1Y1 B A C Discretionary Policy: ∆t or ∆G  ∆SBB  Shift BB line Automatic Stabilization: ∆Y  ∆BB along BB line Y – BB +BB

The Public Debt and the Budget Balance ©2010 McGraw-Hill Ryerson Ltd. Chapter Public Debt (PD) ≡ govt bonds issued to finance BB < 0 The outstanding PD = ∑ ( past BB, + & - ) ΔPD = - BB Public Debt Ratio ≡ PD/Y

Canadian Federal Govt Budget Balances & Public Debt Ratios ©2010 McGraw-Hill Ryerson Ltd. Chapter

Algebra of Income Determination ©2010 McGraw-Hill Ryerson Ltd. Chapter A general model of Y determination: Consumption: C = C 0 + cYD, YD = Y – NT Investment: I = I 0 Govt G = G 0,NT = tY Exports X = X 0 Imports Z = Z 0 + zY AE = C + I + G + X – Z = C 0 + I 0 + G 0 + X 0 – Z 0 + [c(1 – t) – z] Y = A 0 +[c(1 – t) – z] Y

Algebra of Income Determination ©2010 McGraw-Hill Ryerson Ltd. Chapter

The Multiplier in Canada ©2010 McGraw-Hill Ryerson Ltd. Chapter The Multiplier for Canada Estimates for Canada: c(1-t) = 0.54 z = 0.34

AE, AD, & Y e ©2010 McGraw-Hill Ryerson Ltd. Chapter Equil Y = AE AE = A 0 + [c(1 – t) – z]Y Y = A 0 / (1 - c(1 – t) + z) Equil Y & P: AD = AS 45 0 ∆A ∆Y∆Y Y = AE AE A0A0 A1A1 A 0 +[c(1-t)-z]Y A 1 +[c(1-t)-z]Y Y1Y1 Y 0 Y P P0P0 AS AD 0 AD 1 Y1Y1 Y 0 Y ∆Y ∆A  Shift AE  ∆Y  Shift AD = ∆Y  ∆Y P 0

Chapter Summary ©2010 McGraw-Hill Ryerson Ltd. Chapter 7 33 G is part of autonomous spending (A) in AE & AD. Net taxes, NT = tY Net taxes, NT = tY slope of AE multiplier NT  ↓ YD/Y  ↓ ∆C/∆Y  ↓ slope of AE & ↓ multiplier govt’s Budget Balance The govt’s Budget Balance BB = NT – G Fiscal policy: ∆t &/or ∆G  ∆AD  Y = Y P Fiscal policy: ∆t &/or ∆G  ∆AD  Y = Y P Structural budget balance: SBB = NT( Structural budget balance: SBB = NT(Y P ) - G ∆SBB indicates ∆discretionary fiscal policy.

Chapter Summary ©2010 McGraw-Hill Ryerson Ltd. Chapter 7 34 ∆Y/∆A the multiplier. Automatic stabilizers: ↓ ∆Y/∆A the multiplier  smaller business cycle ∆Y’s. = ∑ (past BB), ∆PD = – BB Public Debt = ∑ (past BB), ∆PD = – BB Public Debt Ratio = PD/Y may limit fiscal policy ∆BB < 0 when Y < Y P  stabilization & fiscal stimulus