GOVernment in the economy

Part I: The Effects of Fiscal Policy

Review

• At a minimum, government significantly influences

economic activity by providing the framework within which

households and firms operate.

• More directly, government is itself an economic agent by

virtue of its two broad policy instruments:

• Monetary Policy: the government exercises control over

an economy’s money supply.

• Fiscal Policy: the government levies taxes and also

spends on goods and services.

How government affects the economy.

Taxation

• Taxes represent funds that have to be paid to the

government out of our income.

• This means that our incomes have to be divided not just

between savings and consumption, but taxes as well:

Y = C + S + T

• The taxes that government collects (T) are what finance

government expenditure (G).

• If G < T, the government is running a surplus.

• If G > T, the government is running a deficit.

• If G = T, we have a balanced budget.

Some insights into how taxes factor into economic analysis.

Taxes and Consumption

• The difference between our income and the amount of

taxes that we have to pay is our disposable income.

Yd = Y – T

• This means that consumption is really a function of our

disposable income:

C = a + bYd

• Substituting the former into the latter yields:

C = a + b(Y – T)

• This implies that the saving function is now:

S = –a + (1 – b)(Y – T)

Incorporating taxation into the consumption function.

Government Spending

• Consider: whether government spends or not does not

necessarily have anything to do with how the economy is

doing.

• Government projects can be undertaken for political

rather than economic reasons.

• Government can (hypothetically) spend whether or not it

has the necessary funds to finance its projects.

• If this is the case, we can consider government spending

as another autonomous variable.

Putting the “G” in Planned Aggregate Expenditure (i.e. C + I + G).

Output and Fiscal Policy

• A more complete model of planned aggregate expenditure:

AE = C + I + G

• Substituting:

AE = a + b (Y – T) + I + G

• The equilibrium condition:

Y = AE

• Thus (and rearranging):

Y = (a + I + G) + bY – bT

Putting it all together.

Output and Fiscal PolicyPutting it all together.

We have now derived the equilbrium condition:

Y = 1 ( a + I + G – bT)

1 – b

Consider:

Any change in government

spending changes equilibrium

output by:

Any change in taxation

changes equilibrium output by:

1 – b

1

1 – b

b–

Output and Fiscal PolicyPutting it all together.

We have now derived the equilbrium condition:

Y = 1 ( a + I + G – bT)

1 – b

Consider:

Any change in government

spending changes equilibrium

output by:

Any change in taxation

changes equilibrium output by:

MPS

1

MPS

MPC–

Output and Fiscal PolicyPutting it all together.

We have now derived the equilbrium condition:

Y = 1 ( a + I + G – bT)

1 – b

The Government

Spending Multiplier:The Tax Multiplier:

MPS

1

MPS

MPC–

Fiscal Stimuli

• Recessions represent a downturn in economic performance.

• Recall: they are defined as a decline in output over two

consecutive quarters.

• If ouput declines, it must mean that investments have

declined.

• Government spending can be an effective tool to offset

recessions.

Case 1: Recession

1

MPS– ∆ I

1

MPS∆ G

Decrease in Planned

Investments

Increase in Government

Spending

+ = 0

Fiscal Stimuli

• An economy may be said to be “overheating” when

economic performance leads to rapidly rising output and

income over a short interval.

• The immediate consequence of this is rising inflation and a

rising cost of living.

• Overheating is often kept in check by a commensurate

increase in taxes.

• Fiscal Drag: with rising incomes come rising tax revenue.

Case 2: “Overheating”

Fiscal StimuliCase 3: Balanced Budget Spending

∆ G = ∆ T

What would happen if the govenrment finances an

increase in expenditure by an equal increase in taxes?

From the multiplier:

The change in equilibrium output from a

change in taxes is given by:MPS

MPC– ∆ T

The change in equilibrium output from a

change in government spending is given by: MPS

1∆ G

Fiscal StimuliCase 3: Balanced Budget Spending

The total change in output from “balanced budget spending”:

∆ Y =MPS

MPC– ∆ T

MPS

1∆ G

Since ∆ G = ∆ T:

∆ Y =MPS

MPC– ∆ G

MPS

1∆ G

Fiscal StimuliCase 3: Balanced Budget Spending

Simplifying:

∆ Y =MPS

1 - MPC∆ G

However, (1 – MPC) = MPS! Therefore:

∆ Y =MPS

MPS∆ G

∆ Y = ∆G