THE GOVERNMENT AND FISCAL POLICY Chapter 21 1

THE GOVERNMENT AND FISCAL POLICY Government can affect the macroeconomy through two policy channels: fiscal policy The government’s spending and taxing policies Fisc referring to the treasury of a government monetary policy The behavior of the Central Bank concerning the nation’s money supply 2

THE GOVERNMENT AND FISCAL POLICY Fiscal policy: Policies concerning government purchases of goods and services Policies concerning taxes Policies concerning transfer payments (such as social security benefits) 3

GOVERNMENT IN THE ECONOMY discretionary fiscal policy Changes in taxes or spending that are the result of deliberate changes in government policy 4

GOVERNMENT IN THE ECONOMY GOVERNMENT PURCHASES (G), NET TAXES (T), AND DISPOSABLE INCOME (Y D ) net taxes (T) Taxes paid by firms and households to the government minus transfer payments made to households by the government 5

6

GOVERNMENT IN THE ECONOMY disposable, or after-tax, income (Y d ) Total income minus net taxes: Y − T disposable income ≡ total income − net taxes Yd ≡ Y − T 7

GOVERNMENT IN THE ECONOMY The disposable income (Y d ) of households must end up as either consumption or saving (S) Y d ≡C+S As disposable income is aggregate income (Y) minus taxes (T) Y-T≡C+S Y≡C+S+T 8

GOVERNMENT IN THE ECONOMY When government enters the picture, the aggregate income identity gets cut into three pieces: Government takes a part (net taxes T) Households divide the rest between consumption (C) and saving (S) Planned aggregate expenditure (AE) is the sum of consumption spending by households (C), investment by business firms (I) and government purchases of goods and services (G) AE≡C+I+G 9

GOVERNMENT IN THE ECONOMY budget deficit The difference between what a government spends and what it collects in taxes in a given period: G − T budget deficit ≡ G − T If G>T government must borrow from the public to finance the deficit If G<T government is spending less than it is collecting in taxes, the government is running a surplus 10

GOVERNMENT IN THE ECONOMY Adding Taxes to the Consumption Function To modify our aggregate consumption function to incorporate disposable income instead of before-tax income, instead of C = a + bY, we write C = a + bY d C = a + b(Y − T) Our consumption function now has consumption depending on disposable income instead of before-tax income 11

GOVERNMENT IN THE ECONOMY Investment The government can affect investment behavior through its tax treatment of depreciation and other tax policies For our present purposes, we continue to assume that planned investment (I) is autonomous 12

GOVERNMENT IN THE ECONOMY EQUILIBRIUM OUTPUT: Y = C + I + G 13

GOVERNMENT IN THE ECONOMY equilibrium condition: Y = C + I + G If Y>AE=C+I+G unplanned increase in inventories If Y< C+I+G unplanned decrease in inventories An example: C= Y d Introduce government sector C= (Y-T) Government purchases G=100 Net taxes T=100 Government is running a balanced budget that is financing all of its spending with taxes Planned investment I=100 14

15

GOVERNMENT IN THE ECONOMY The Leakages/Injections Approach to Equilibrium Aggregate income flows into households and consumption and saving flow out Saving flowing from households into the financial market is used by firms to finance their investment projects If planned investment of firms equals the saving of households, then planned aggregate expenditure (AE=C+I) equals aggregate output (income) (Y) and there is equilibrium The leakage out of the spending stream (saving) is matched by an equal injection of planned investment spending into the spending stream 16

GOVERNMENT IN THE ECONOMY Taxes (T) are a leakage from the flow of income Saving (S) is also a leakage In equilibrium, aggregate output (income) (Y) equals planned aggregate expenditure (AE), and leakages (S + T) must equal planned injections (I + G) Algebraically, AE=C+I+G Y=C+S+T At equilibrium Y=AE C+S+T=C+I+G S+T=I+G leakages/injections approach to equilibrium: S + T = I + G 17

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS Assume that Y=900 YTL, G=100 YTL, T=100 YTL, I=100 YTL As a policy maker you want to increase output and income to 1100 YTL How can the government use taxing and spending policy (fiscal policy) to increase the equilibrium level of output? Not possible to increase taxes Change government spending G 18

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS How much of an increase in spending would be required to generate a 200 YTL increase in the equilibrium level of output? Answer → because we need to increase income by 200 YTL, we should increase government spending by the same amount (wrong) Increase in G → AE increases by 200 YTL → AE>Y inventories will be lower than planned → firms will have incentive to increase output → more to the story than this 19

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS As Y rises → the economy is generating more income → creation of more employment → newly employed workers increase consumption spending → planned spending will be higher than output (AE>Y) → inventories will be lower than planned → firms will raise output → thus raise income again Familiar multiplier in action 20

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS 21

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS THE GOVERNMENT SPENDING MULTIPLIER government spending multiplier The ratio of the change in the equilibrium level of output to a change in government spending Government spending multiplier≡1/MPS An increase in government spending has the same impact on the equilibrium level of output and income as an increase in planned investment 22

23

DERIVING THE GOVERNMENT SPENDING MULTIPLIER ALGEBRAICALLY Recall that our consumption function is: C = a + b(Y-T) where b is the marginal propensity to consume. In equilibrium: Y = C + I+G Now we solve these two equations for Y in terms of I. By substituting the first equation into the second, we get: 24

DERIVING THE GOVERNMENT SPENDING MULTIPLIER ALGEBRAICALLY Y =a + b(Y –T)+ I+G Y =a + Y –bT+ I+G Y-bY=a+I+G-bT Y(1-b)=a+I+G-bT We can then solve for Y in terms of I by dividing through by (1 − b): 25

DERIVING THE GOVERNMENT SPENDING MULTIPLIER ALGEBRAICALLY The multiplier is 26

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS THE TAX MULTIPLIER Remember that fiscal policy comprises policies concerning government spending and policies concerning taxation The effect of a change in tax policy on the economy? The multiplier for a change in taxes is not the same as the multiplier for a change in government spending 27

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS Previous problem revised As a policy maker you want to increase output How can the government use taxing and spending policy (fiscal policy) to increase the equilibrium level of output? This time you do not want to increase government spending (G) Change taxation policy 28

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS Decide to cut taxes and maintain the current level of government spending A tax cut increases disposable income This increased income leads to increased consumption The question → Would decrease in taxes affect aggregate output (income) the same as an increase in government spending (G)? 29

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS A decrease in taxes → increase income Households → higher disposable income → increase consumption → Planned aggregate expenditure increases (AE>Y) → Inventories will be lower than planned → A rise in output As Y rises → creation of more employment → more income will be generated → causing a second-round increase in consumption Familiar multiplier in action 30

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS Why does the tax multiplier differ from the spending multiplier? When government increases spending, there is an immediate and direct impact on the economy’s total spending When taxes are cut, there is no direct impact on spending Taxes enter picture only because they have an effect on the household’s disposable income, which influences household’s consumption (that is a part of AE) The tax cut flows through households before affecting AE 31

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS Assume the government decides to cut taxes by 1 TL When government spending increase by 1 TL, AE increases initially by the full amount of the rise in G When taxes are cut, the initial increase in AE is only the MPC times the change in taxes (due to affecting disposable income) As the initial increase in AE is smaller for a tax cut than for a government spending increase, the final affect on the equilibrium level of income will be smaller 32

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS tax multiplier The ratio of change in the equilibrium level of output to a change in taxes The final change in the equilibrium level of output (income) (Y) ∆Y=(∆AE)x(1/MPS) The initial change in aggregate expenditure caused by a tax change of ∆T → (-∆TxMPC) 33

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS ∆Y=(∆AE)x(1/MPS) ∆Y=(-∆TxMPC)x(1/MPS) Tax multiplier → -(MPC/MPS) A tax cut will cause an increase in consumption and output, so tax multiplier is negative 34

DERIVING THE TAX MULTIPLIER ALGEBRAICALLY Y = C + I+G Y =a + b(Y –T)+ I+G Y-bY=a+I+G-bT Y(1-b)=a+I+G-bT We can then solve for Y in terms of I by dividing through by (1 − b): 35

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS THE BALANCED-BUDGET MULTIPLIER What if government spending and taxes are increased by the same amount? The government decides to pay for its extra spending by increasing taxes by the same amount The government’s budget deficit would not change because ∆G=∆T 36

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS What is the effect on equilibrium income of equal increases in government spending and taxes? If government spending increase by 40 TL (MPC=0.75), with taxes (T) held constant, should increase the equilibrium level of income by ∆Y=(∆G) x government spending multiplier ∆Y=(∆G)x(1/MPS) ∆Y=(40)x(1/0.25)=(40x4)=160 37

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS Now suppose that instead of keeping tax revenues constant, we finance the 40 increase in G with an equal increase in T, so as to maintain a balanced budget What happens to AE as a result of both the rise in G and the rise in T? Two initial effects G increases by 40 (direct and positive effect) T increases by 40 (negative effect on overall spending) 38

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS The final effect of T increase on AE depends on how households respond to it MPC=0.75 and MPS=0.25 When disposable income falls, both C and S are reduced A tax (T) increase of 40 → reduces disposable income by 40 → consumption falls by 40xMPC As MPC=0.75, ∆C=40xMPC=30 The net result is increase in G → ∆G=40, decrease in C → ∆C=30 → AE increases ∆AE=10 39

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS A balanced-budget increase in G and T will raise output but by how much? balanced-budget multiplier The ratio of change in the equilibrium level of output to a change in government spending where the change in government spending is balanced by a change in taxes so as not to create any deficit The balanced-budget multiplier is equal to 1: The change in Y resulting from the change in G and the equal change in T is exactly the same size as the initial change in G or T itself 40

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS Combine the tax multiplier and the government spending multiplier The final effect of a simultaneous increase in G and increase in T, add the multiplier effects of the two Government spending multiplier = 1/MPS Tax multiplier = -MPC/MPS Their sum (1/MPS)+(-MPC/MPS) = (1-MPC)/MPS = MPS/MPS =1 41

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS So, a 40 increase in G would increase equilibrium output by 160 [40 x government spending multiplier = 40x(1/MPS)=40x(1/0.25)] A 40 tax increase will reduce the equilibrium level of output by 120 [40 x tax multiplier = 40x(MPC/MPS)=40x(0.75/0.25)] The net effect= =40 The net effect on equilibrium level of Y resulting from the change in G and the change in T is exactly the size of the initial change in G or T itself 42

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS Previous problem revised again Assume that Y=900 TL, G=100 TL, T=100 TL, I=100 TL As a policy maker you want to increase output and income to 1100 TL How can the government use taxing and spending policy (fiscal policy) to increase the equilibrium level of output without increasing the deficit? Simultaneous increase in G and T of 200 would increase output by

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS 44

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS An increase in government spending has a direct initial effect on planned aggregate expenditure; a tax increase does not The initial effect of the tax increase is that households cut consumption by the MPC times the change in taxes This change in consumption is less than the change in taxes, because the MPC is less than 1 The positive stimulus from the government spending increase is thus greater than the negative stimulus from the tax increase The net effect is that the balanced-budget multiplier is 1 45

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS 46

DERIVING THE BALANCED-BUDGET MULTIPLIER ALGEBRAICALLY When T and G increase simultaneously, two effects on AE: Increase in G (∆G) Decrease in consumption (∆C) caused by T increase → ∆C = ∆T(MPC) Net increase in AE = increase in AE -decrease in AE ∆G - ∆C [= ∆T(MPC)] = ∆G - ∆T(MPC) 47

DERIVING THE BALANCED-BUDGET MULTIPLIER ALGEBRAICALLY In a balanced-budget increase ∆G=∆T Net increase in AE = ∆G - ∆T(MPC) = ∆G - ∆G(MPC) = ∆G(1-MPC) As 1-MPC = MPS Net increase in AE = ∆G(MPS) As ∆Y = ∆AE x spending multiplier (1/MPS) ∆Y = ∆G(MPS)x(1/MPS) = ∆G 48