1. Chapter 17 Fiscal policy and foreign trade
©McGraw-Hill Companies, 2010

2. ©McGraw-Hill Companies, 2010
Some key terms
Fiscal policy
the government’s decisions about spending and taxes
Stabilisation policy
government actions to try to keep output close to its potential level
Budget deficit
the excess of government outlays over government receipts
National debt
the stock of outstanding government debt
©McGraw-Hill Companies, 2010 2

3. Government in the income-expenditure model
Direct taxes
affect the slope of the consumption function
and hence the slope of the AD schedule.
Government expenditure affects the position of the AD schedule.
©McGraw-Hill Companies, 2010 3

4. ©McGraw-Hill Companies, 2010
Fiscal policy
AD1
This seems to suggest
that the government could influence aggregate output in the economy by raising AD from AD0 to AD1,
45o line
Aggregate demand
AD0 Y1
thus raising equilibrium
output from Y0 to Y1.
But this ignores some
important issues –
prices, interest rates, and the need to fund the government spending. Y0
Income,
output
©McGraw-Hill Companies, 2010 4

5. ©McGraw-Hill Companies, 2010
The government budget
The budget deficit = total government spending, minus total tax revenue.
If government spending is independent of income, G
G, NT
but net taxes depend on income, NT Y0
The balanced budget multiplier states that an increase in government spending plus an equal increase in taxes leads to higher equilibrium output.
Balanced
budget
then the budget will be in deficit at low levels of income but in surplus at high levels.
Income, output
©McGraw-Hill Companies, 2010 5

6. Deficits and the fiscal stance
The size of the budget deficit is not a good measure of the government’s fiscal stance.
The structural budget shows what the budget would have been if output had been at the full-employment level.
The inflation-adjusted budget uses real not nominal interest rates to calculate government spending on debt interest.
©McGraw-Hill Companies, 2010 6

7. Automatic stabilisers
mechanisms in the economy that reduce the response of GNP to shocks
for example, in a recession:
payments of unemployment benefits rise
and receipts from VAT and income tax fall
©McGraw-Hill Companies, 2010 7

8. Limits on active fiscal policy
Why can’t shocks to aggregate demand immediately be offset by fiscal policy?
Time lags: it takes time
to diagnose the problem
to take action
for the multiplier process to operate
Uncertainty
the size of the multiplier is not known
aggregate demand is always changing
Induced effects on autonomous demand
changes in fiscal policy may induce offsetting effects in other components of aggregate demand
©McGraw-Hill Companies, 2010 8

9. Limits on active fiscal policy (2)
Why doesn’t the government expand fiscal policy when unemployment is persistently high?
The budget deficit
concern about inflation if the budget deficit grows
Maybe we’re at full employment!
unemployment may be (at least partly) voluntary
©McGraw-Hill Companies, 2010 9

10. Foreign trade and income determination
Introducing exports (X) & imports (Z)
Trade Balance
the value of net exports (X - Z)
Trade Deficit
when imports exceed exports
Trade Surplus
when exports exceed imports
Equilibrium is now where
Y = C + I + G + X - Z
©McGraw-Hill Companies, 2010 10

11. Exports, imports & the trade balance
Assume that exports are independent of
income,
Exports
but that imports increase with income.
Imports
X, Z
At higher income levels, there is a trade deficit.
At relatively low income, exports exceed imports
– there is a trade surplus.
There is trade balance at income Y*, but there is no guarantee that this corresponds to full employment. Y*
Income
©McGraw-Hill Companies, 2010 11

12. Foreign trade and the multiplier
The marginal propensity to import
is the fraction of additional income that domestic residents wish to spend on additional imports.
The effect of foreign trade is to reduce the size of the multiplier
the higher the value of the marginal propensity to import, the lower the value of the multiplier.
©McGraw-Hill Companies, 2010 12

13. Some maths: The multiplier
Equilibrium is where:
Y* = C + I + G + X – Z
where C = A + c(1-t)Y and Z = zY.
c = marginal propensity to consumer; t = the tax rate and z the marginal propensity to import.
Hence:
Y* = [A + G + X + I] + c(1-t)Y – zY
Equilibrium dictates Y*=Y and hence:
Y* = [A + I + G + X ]/[ 1 – c(1-t) + z ]
©McGraw-Hill Companies, 2010 13

14. Y* = [A + I + G + X ]/[ 1 – c(1-t) + z ]
Equilibrium output is the product of autonomous spending - autonomous consumption demand A, plus injections from investment, government spending, and exports
and the multiplier {1 / [ 1 – c(1-t) + z ]}
In a small open economy, the marginal propensity to import z will be much higher than in a large closed economy such as the United States.
Hence the multiplier will be lower in Belgium than in the USA.
©McGraw-Hill Companies, 2010 14