Government intervention and fiscal policy Adding a government to the goods market equilibirum

Government intervention and fiscal policy Today we examine a simple extension to last week’s analysis of the equilibrium in the goods market. A specific agent is introduced (the government), which controls two extra variables in aggregate demand: taxes and expenditure We analyse how the presence of the government changes the situation in the markets

Government intervention and fiscal policy The debate about role of the government in influencing the goods market equilibrium is visible in the current affairs: Most economies are in recession/depressed, with a low level of output relative to their potential As a result, most countries have put in place “output stimulus plans”, such as the 800 bill $ US plan There is currently a debate on the sustainability of such deficits

Government intervention and fiscal policy But there are questions around this: Why is it necessary for the government to intervene is such circumstances (i.e. Not a matter of ideology) ? How big must the intervention be ? Why does the debate around government more expenditure vs. tax cuts matter ? Simple models can actually explain all this quite well...

Government intervention and fiscal policy Aggregate demand and the government The different multipliers The role of the government in the savings-investment gap

Aggregate demand and the government The government controls two variables that were omitted last week: Government spending G Taxes T These variables represent the government's budget: If G - T > 0 there is a budget deficit If G - T < 0 there is a budget surplus If G - T = 0 the budget is balanced

Aggregate demand and the government These two variables usually enter aggregate demand as follows: First, government spending enters aggregate demand directly: Z = C + I + G Second, taxes T are paid by agents out of their income, thus reducing their disposable income C = C 0 + c (Y – T )

Aggregate demand and the government As a result, the detailed aggregate demand equation becomes: Z = C 0 + c (Y – T ) + I + G We still consider investment to be exogenous (for the moment) The equilibrium condition on the market does not change: it still is Y = Z

Aggregate demand and the government Income, output Y Aggregate Demand (planned expenditure) Z = C 0 + c (Y – T ) + I + G mpc: 0<c<1 Aggregate demand as a function of income Autonomous demand (not a function of Y ) C 0 - cT+ I + G Aggregate Demand Z Changes from last week

Aggregate demand and the government 45° Effective expenditure Y = Z Keynesian Equilibrium Output Y* Income, output Y Aggregate Demand (planned expenditure) Z = C 0 + c (Y – T ) + I + G Equilibrium on the goods market, with government Aggregate Demand Z

Aggregate demand and the government So the aggregate demand curve and the market equilibrium diagram solve the same way as last week. This means that one can find the equilibrium level of output Y* the same way as we did last week Set Y = Z Solve for Y* by isolating output on the left-hand-side of the equation

Aggregate demand and the government We have the following market equation and equilibrium condition Setting Y = Z Isolating Y on the left hand side

Aggregate demand and the government This gives the equilibrium level of output: One can see at this point that the main effect of the government intervention: Is not really to change the size of the multiplier The government, however, can influence the size of the autonomous demand in the economy Multiplier Autonomous demand (exogenous)

Government intervention and fiscal policy Aggregate demand and the government The different multipliers The role of the government in the savings-investment gap

The different multipliers Last week, we saw that there was an investment multiplier ΔY/ΔI Equal to 1/(1-c ) Referred to as “the” multiplier In fact, there are several sorts of multipliers Last week, investment was the only exogenous variable Introducing G and T means more multipliers Will see some again when we introduce international trade.

The different multipliers The spending multiplier Corresponds to the increase in output following an increase in government spending G Given equilibrium output: It is equal to This is the same as last week’s investment multiplier

The different multipliers The tax multiplier Corresponds to the change in output following an increase in taxes T Given equilibrium output: It is equal to: This is a new multiplier, different from last week

The different multipliers The tax multiplier This multiplier is negative  An increase in taxes leads to a fall in output It is smaller in absolute value than the spending multiplier Tax cuts aren’t as effective as government spending in stimulating output.

The different multipliers The tax multiplier Let’s go back to the aggregate demand and the equilibrium output to see why: Increased government spending G enters aggregate demand directly, but tax cuts enter indirectly, through disposable income (Y-T ) So some of the tax cut is directly saved, which reduces the multiplier effect.

The different multipliers Balanced budget multiplier The fact that the tax and spending multipliers are different sizes means that there is a balanced budget multiplier Let’s start with a balanced budget G=T The net effect of a change in spending and taxes is:

The different multipliers Balanced budget multiplier In the case of a balanced budget increase we have ΔG = ΔT The balanced budget multiplier is equal to 1!

Government intervention and fiscal policy Aggregate demand and the government The different multipliers The role of the government in the savings-investment gap

The role of the government in the S-I gap So we have established that the government can change the equilibrium level of output: By varying the level of its deficit (G-T ) Several policy options are available for “fine- tuning”: changes in taxes, in spending, even in the absolute size of the budget. But surely, budget deficits are a bad thing? Like every economic agent, the state needs to balance its books, so it should keep G=T This is known as the “treasury view”

The role of the government in the S-I gap But this view ignores the fact that the state is a special agent, and that fiscal policy plays a central role in the economy. This can be understood by examining the 2 nd interpretation we saw last week: The Y=Z equilibrium condition can always be interpreted as a savings = planned investment condition But first of all, we need to work out this alternative equilibrium condition.

The role of the government in the S-I gap Expenditure (Aggregate demand) is equal to: Z= C + I + G Income can be divided up into: Y = C + S + T At equilibrium we have Y=Z. This gives: C + I + G = C + S + T I + (G-T) = S Alternatively: G-T = S-I Planned private investment Public investmentPlanned savings

The role of the government in the S-I gap If I > S (planned investment higher then planned savings) The state can bring the economy to equilibrium by running a surplus (G <T ), which supplies extra (public) savings If I < S (planned investment lower then planned savings) The state can bring the economy to equilibrium by running a deficit (G >T ) which “mops up” the excess savings with public investment G-T = S-I

The role of the government in the S-I gap What about the current situation? Planned investment is at a record low: because of the recession (and expected depression) firms are cutting back on investment plans. Planned savings are high: agents are anxious about the future or realise the high levels of private debt need to be paid back. So large public deficits are needed to bring these economies back to equilibrium Trying to balance the budget NOW would only prolong the situation (like in the 1930’s) G-T = S-I