Lecture 20: Government Expenditure L11200 Introduction to Macroeconomics 2009/10 Reading: Barro Ch March 2010

Government Expenditure Model so far considered household sector only – In reality, governments are big players in the economy – Government spending = 30-50% GDP Begin with overview of U.K. government spending from Financial Times –

Government Budget Constraint Governments, like households, have a budget constraint Government one-period budget constraint: In practice, revenue from money creation is very small, so disregard this government spending + government transfers = tax revenue + real revenue from money creation

Government Activity Explaining the budget constraint – Governments tax households to raise income – They spend some money directly on goods and services (e.g. national health service) on behalf of the population – They provide transfers of money directly to some households (e.g. benefits) – Initially assume government spending /transfers yield no utility to households

Households Budget Constraint Government taxes and transfers alter household budget constraint – If household receive benefits (i.e. transfer of money from the government) they are better off – If they have to pay tax, they are worse off – So net effect depends on combination of these factors

Households Budget Constraint Modified budget constraint (in present value) V=transfer from govt. T=tax paid to govt. Taxation is just a lump-sum per period present value of consumption = value of initial assets + present value of wage incomes + present value of transfers net taxes

Taxes and Transfers So impact of household depends on net effect – If household is net recipient of transfers, it is a net beneficiary from the government – If household is a net tax payer, it is a net contributor to the government Government intervention gives rise to an income effect – Net Beneficiaries: positive (more consumption, more leisure) vice versa for net contributors

Permanent Change in Policy Suppose government decides to increase spending by 1 unit per year, forever – Income falls permanently, so consumption falls permanently by 1 unit per year – Does spending have any impact on output, employment, capital investment?

Effect on Output, Capital, Labour Increased government spending – Decreases resources available for households to spend – Doesnt change MPK, R/P or MPL, w/P – no impact on demand for labour or capital – If K and L are fixed (as in earlier model) – no impact on supply of labour or capital – So no change in households decision about output, Y, or capital use or employment

Effect on Interest Rates Equilibrium condition for interest rates: Return to capital unchanged – Hence return to bonds unchanged – So only effect of increase in government spending by one unit is to decrease household consumption, permanently, by one unit Real rate of return on bonds = real rate of return from owning capital

Temporary Change in Policy If increase in expenditure is temporary – Household resources fall for one period, then increase back to original level – Effect on lifetime wealth much smaller, so effect on current consumption is much smaller – Household smooth over change in government spending in the same way they smooth over temporary change in income.

Temporary Real Effects As with a permanent change, temporary change leaves most real activity unaffected – But as consumption fall is smaller, some investment is sacrificed – Permanent increase in G caused 1:1 fall in C – Temporary increase in G causes <1 fall in C, so investment falls to offset G

Summary Government large player in economy – Spends ~ 30% GDP, employs ~25% workforce – In simple model, government activity lowers household resources – Similar to permanent / temporary change in income So far, simple treatment of taxation – Next time: what to tax and why