Chapter 16: FISCAL POLICY Fiscal Policy and its effect on Aggregate Demand & aggregate supply

What is GOVERNMENT BUDGET? The government budget is an annual statement of the revenues, the outlays, and surplus or deficit of the government.

What is FISCAL POLICY? Fiscal Policy: The use of the government budget to achieve the macroeconomic objectives of high and sustained economic growth and full employment.

Fiscal Policy & Aggregate Demand Fiscal Policy can take the form of a change in the government outlays or a change in the tax revenues. And a change in government outlays can take the form of a change in expenditure on goods and services or a change in transfer payment.

Fiscal Policy & Aggregate Demand Other things remaining the same a change in any of the items in the government budget changes aggregate demand and has a multiplier effect. Aggregate Demand changes by a greater amount than the initial change in the item in the government budget

The Government Expenditure Multiplier The government expenditure multiplier shows the effect of a change in government expenditure on goods and services on aggregate demand the effect of a change in government expenditure on goods and services on aggregate demand Government expenditure is a component of aggregate expenditure, so when government expenditure increases, the aggregate demand curve increases. Therefore real GDP increases and encourages an increase in the consumption expenditure, which brings a further increase in the aggregate expenditure.

The Government Expenditure Multiplier The Government Expenditure Multiplier is the magnification effect of a change in government expenditure on aggregate demand.

The Tax Multiplier The tax multiplier shows the effect of a change in taxes on aggregate demand. The Tax Multiplier is the magnification effect of a change in taxes on aggregate demand. A decrease in taxes increases disposable income, which increases consumption expenditure.

The Tax Multiplier The magnitude of tax multiplier is smaller than the government expenditure multiplier because “a $1 tax cut generates less than $1 of additional expenditure.”

The Tax Multiplier The marginal tendency to consume determines the initial increase in expenditure induced by a tax cut and the magnitude of the tax multiplier. Example: if the marginal tendency to consume is 0.75, then the initial increase in consumption expenditure induced by a $1 tax cut is only 75 cents. In this case, the tax multiplier( with negative sign is) 0.75 times the magnitude of the government expenditure multiplier.

The Transfer Payments Multiplier This multiplier works like the tax multiplier but in the opposite direction. An increase in transfer payments increases disposable income, which increases consumption expenditure. The magnitude of the transfer payments multiplier( with positive sign) is similar to that of the tax multiplier. The transfer payments multiplier shows the effect of a change in the transfer payments on aggregate demand.

The Transfer Payments Multiplier It is the marginal propensity to consume that determines the increase in expenditure induced by an increase in transfer payments. Example: a $1 tax cut generates less than $1 of additional expenditure, so also does a $1 increase in transfer payments.

The Balance Budget Multiplier The balance budget multiplier is not zero. It is greater than zero because “a $1 increase in government expenditure injects a dollar more into the aggregate demand while a $1 tax rise (or decrease in transfer payments) takes lass than $1 from aggregate demand.” So when both government expenditure and taxes increase by $1, aggregate demand increases. Definition: the effect on aggregate demand of a simultaneous change in government expenditure and taxes that leaves the budget balance unchanged.

A Successful Fiscal Stimulus If real GDP is below potential GDP, the government might practice a fiscal stimulus by: Increasing its expenditure on goods & services Increasing transfer of payments Cutting taxes (reducing taxes) Or a combination of all three.

Fiscal Stimulus: When Real GDP is low:

Figure 6.1: Illustration

Fiscal Stimulus: When Real GDP is low

Figure 6.2: Illustration The fiscal stimulus introduced by the government would change the AD0 curve to AD0 + E. The initial increase in expenditure sets off a multiplier process, which increases the consumption expenditure. As the multiplier process plays out, aggregate demand increases and AD curve shifts rightward to AD1. Since the price level is not changing, therefore, the economy moves from A to B. But the increase in aggregate demand combined with the upward-sloping aggregate supply {AS} curve bring a rise in price level and so the economy moves to C. The price level rises to 110, real GDP to $ 13 trillion and the economy returns to full-employment.

A Successful Contractionary Fiscal Policy If real GDP is greater than the potential GDP, the government practices a contractionary fiscal policy. The Contractionary Fiscal Policy: A decrease in the government expenditure on goods and services, decrease in the transfer payments, or raise in taxes designed to decrease aggregate demand.

Contractionary Fiscal Policy: Above Full Employment

Figure 6.3: Illustration In the figure, potential GDP is $ 13 trillion but real GDP is $ 14 trillion. The economy is at point {A}. The yellow-arrow shows the inflation gap. To eliminate the recessionary gap and restore full employment, the government decreases expenditure or rises taxes, to decrease aggregate expenditure by E. This increase is illustrated in figure 6.4, where full employment is achieved.

Contractionary Fiscal Policy: Above Full Employment

Figure 6.4: Illustration

The Supply Side: Potential GDP & Growth Fiscal policy can influence the output gap by changing the aggregate demand and the real GDP relative to the potential GDP. But fiscal policy also influences potential GDP and the growth rate of potential GDP. These influences rises because the government provides public goods and services that increase productivity and because taxes change the incentives that affect people. These influences are called SUPPLY-side effects, operates more slowly than the DEMAND-side effects.

The Supply Side: Potential GDP & Growth In recession: Supply-side effects are ignored as the focus is on fiscal stimuli and restoring full employment. In the long-run: Supply-side effects will dominate and determine the potential GDP. First we consider that how, in the absence of government services and taxes ,the full employment and potential GDP are determined.

The Supply Side: Full Employment & Potential GDP The quantity of labor demanded and supplied depend on real wage rate. The higher the wage rate, other things remaining the same, the smaller is the quantity of labor demanded and the greater is the quantity of labor supplied. When the wage rate is adjusted to equal the quantity of labor demanded and supplied – there is full employment. When it is full employment , the real GDP is equals potential GDP.

The Supply Side: Full Employment & Potential GDP With consideration of government services and taxes: Both sides of the government budget influence the potential GDP. The expenditure side provides the public goods and services that increases productivity. This increase in productivity increases the potential GDP. On the revenue side, taxes modify the incentives and change the full-employment quantity of labor (i.e. the equilibrium of demanded and supplied labor), as well as the amount of saving and investment.

The Supply Side: Public Goods and Productivity The government provides a legal system and other infrastructure services – which increase the nation’s productivity. Public goods and services financed by government, increase the real GDP that a given amount of labor can produce. This means the provision of public goods and services increases potential GDP.

The Supply Side: Taxes and Incentives An increase in taxes drives a wedge between the price paid by a buyer and the price received by a seller. In the labor market income tax drives a wedge between the cost of labor to employers and the take-home pay of workers. Income tax lowers the incentive to work , save and invest and decreases the full-employment quantity of labor. Therefore the potential GDP becomes lower and the aggregate supply curve shifts to the left.

The Supply Side: Taxes and Incentives Taxes on consumption expenditure add to the tax wedge that lowers the potential GDP. The reason is that a tax on consumption expenditure raises the prices paid for consumption goods and services and is equivalent to a cut in the real wage rate. Therefore, the higher the tax on consumption expenditure, the smaller is the quantity of goods and services that an hour of labor can buy and the weaker is the incentive to the supply labor.