TUTORIAL 6 (28 APRIL – 2 MAY) – ANSWER KEY

Fiscal Policy
Textbook Reference: Chapter 6
Main Concepts
Government expenditure
Taxation
Endogenous taxes
Automatic Stabilisers
Balanced budget multiplier
Public Debt
Review Questions
Question 1
This question illustrates the workings of automatic stabilisers. Suppose the components of
planned spending in an economy are
̅
̅
̅
̅
where t is the tax rate. In this economy, the tax system acts as an automatic stabiliser,
because tax revenues automatically decline when national income falls.
(i)
Solve for an equation that determines the short-run equilibrium output for this
economy.
Since imports are zero,

,
̅

̅
̅
̅
[ ̅

̅
Where [ ̅
In equilibrium,

̅

̅
̅

̅

̅]

̅ ] is exogenous expenditure and [
[ ̅

̅
̅

̅]
[ ̅

[

]

[

] is induced expenditure.

[ ̅

]

[ ̅

̅
̅

̅]
̅

̅
̅

̅

̅]
̅]

The last line is short-run equilibrium when taxes are endogenous, or proportional to output.

e. With income taxes: [ Without income taxes: ] . the amount that output changes when exogenous expenditure changes by one unit. Short-run equilibrium output is equal to the multiplier times autonomous expenditure. It has often been said that this is driven by the fact that the expansions being milder due to the higher tax rate. according to empirical evidence. i. the fall in output would be lower than had the tax rate been lower.e.8 and t=0. When there are only exogenous taxes: [ ̅ ̅ ̅ ̅ ̅] So that the multiplier is: [ ] It can be shown that: [ If ] [ ] .(ii) Find the expression for the multiplier. The multiplier for a change in exogenous government expenditure is: [ ] So that for any change in an exogenous variable. endogenous) reduces the size of the multiplier. for example. For any fluctuation in autonomous expenditure.25. So changes in the economy that reduce the multiplier tend to stabilise output. the less output would fluctuate. (v) Suppose that c=0. the smaller the multiplier. (iv) Explain how reducing the size of the multiplier (or increasing the tax rate t) helps to stabilise the economy. the change in short run equilibrium output is: [ ] (iii) Compare the formula for the multiplier in (ii) with the case when taxes are exogenous. Show that making taxes proportional to income (i. With a higher tax rate. For example. contractions are most often led by a fall in autonomous investment. a change in government expenditure . calculate the multiplier.

But a tax cut (exogenous taxes) of $50 billion will raise PAE by the (smaller) amount of $[(c-m)*50] billion. ̅ ̅ Thus the increase in government expenditure is predicted to have the greater impact on aggregate demand. The increase in government expenditure raises autonomous (or exogenous) planned aggregate expenditure by $50 billion. . Which policy is likely to increase planned aggregate expenditure by more? Explain. one involving increased government purchases of $50 billion and the other involving a cut in exogenous taxes of $50 billion. To see the effects on PAE it is useful to write the equation for the 4-sector model. which also stimulates planned aggregate expenditure by raising consumption spending. but there is also a “leakage” via purchases of imports. Use the AE model to illustrate your answer. The cut in exogenous taxes raises disposable income by $50 billion. Note that the lecture notes may have a slightly different version of the four sector model to the textbook: Equation for PAE in 4-Sector Model ̅ where ̅ and ̅ [ ̅ ̅ ( ̅ ̅ and ̅ ( ̅ ̅ ) ) ] You can see that an increase in G of $50 billion will directly raise PAE by $50 billion.Question 2 (i) The government is considering two alternative policies. If: .

exogenous expenditure is constant at the value E. This refers to the marginal income tax rate . At the level of output Y0. Is the effect different from a cut in the exogenous component of taxation? Note the use of the expression ‘tax rate’. Some issues to consider include: • Inflexibility and lags in the implementation of fiscal policy • Persistent budget deficits. . planned aggregate expenditure is greater than output. the use of fiscal policy more complicated than what is suggested by the AE model? Fiscal policy is more complicated. a decrease in the tax rate from t0 to t1 will increase the slope of the planned aggregate expenditure line. This results in an unintended decline in inventories. As the tax rate affects the slope of the planned aggregate expenditure line. in practice. (iii) Discuss the reasons why. In the diagram below.(ii) Explain the effect of a cut in the tax rate on an economy’s planned AE. crowding-out of private investment and a large public debt • Supply-side effects (on potential output) from fiscal policy See BOF section 6. The economy reaches short run equilibrium where PAE2 is equal to Y1. An increase in the exogenous component of taxation will lead to a parallel shift upwards of the planned aggregate expenditure line. and output increases inducing even greater expenditure.3 p174-177. Specifically. a decrease in the tax rate is quite different to a decrease in the exogenous component of taxation. Firms respond by increasing production. and a decrease in the tax rate increases the slope which gives and initial increase in planned aggregate expenditure from PAE0 to PAE1.

over period = transfer payments. Chapter 6) of BOF.(and/or) raise taxes. levied on outstanding debt at end of period . (iii) We can think of the Greek situation as being one in which additional government borrowing (at least from financial markets) is no longer possible. . Does it mean that a government must balance its budget on a year to year basis? Why not? The government budget constraint can be used to think about the options by which the Greek debt crisis might be resolved. If the government budget constraint becomes .Reduce spending and transfers . (i) What does each variable in above equation denote? = government purchases. The government budget constraint implies that government expenditure ( ) must be financed either by taxes or by government borrowing. (ii) Explain in words the implications of the government budget constraint. Now the Greek government has to fund its government spending. The one change to the equation is that in the above case the real interest rate is not constant over time. transfers and interest payments out of its taxation revenue. Provided the government can borrow (and lend) then the budget does not need to be balanced on an annual basis. If this is the case then what are the only options available to the Greek government to solve the crisis. The other options are to: . over period = interest payments. over period = new government borrowing. = taxes. Obviously one possibility is that it does not meet interest payments (and any repayments) and so effectively defaults on its debt. In terms of the above equation we have . at interest rate determined in the previous period .Discussion Questions Question 3 The following equation is a version of the government budget constraint from page 185. the difference between the outstanding debt stock from the end of period and the end of period .

since Greek debt is denominated in Euros and Greece cannot just print additional Euros at will. In this case the Greek government could always pay-off its debts (borrowings) by printing some more of its currency. If Greece issued its own currency (like Australia) there would be an additional term in the government budget constraint. . However.(iv) In terms of the government budget constraint how does a “bailout” of Greece by the other Eurozone countries work? Another possible option (that is not in the above constraint) is for a Greek bailout – by other countries in the Euro zone. which reflects (what is commonly called) “printing money”. it does not have this option. BOF (page 185) discuss the option of governments printing money to finance a budget deficit. Eurozone countries may be obliged to do so for the collective benefit of the Eurozone. Does Greece have this option? Explain. (v) Although it is not included in the above equation. Basically the other countries just make a transfer for Euros to Greece so that it can meet its debt obligations. Of course what Greece could do (and what is roughly equivalent) is to leave the Euro area and introduce its own currency.