Session 9 (Source: Sloman, J.

2006, Economics, FT Pearson,

Harlow) Chapter 17
Learning Objectives
1. Explain the aims and tools of fiscal policy.
2. Calculate and apply the (government)
spending multiplier and the tax multiplier.
3. Analyze the effects of changes in
government spending and taxes on the
economy.
4. Explain the limitations of fiscal policy, the
problems of budget deficit and crowding out
effect.
5. Analyze the balanced budget multiplier
and role of automatic stabilizers.
FISCAL POLICY AND MONETARY
POLICY
The government can affect the
economy through
• Fiscal policy
–government’s budget policy
(spending and taxing decisions)
• Monetary policy
–decisions of the nation’s central
bank regarding the nation’s
money supply.
 FISCAL POLICY
Include
• the collection of taxes and the payment of
transfer payments such as welfare benefits
or unemployment benefits – into a category
we will call net taxes (T).
T = tax paid by households and firms minus
transfer payments made to households by
the government.
• government purchases of goods and services
or government expenditure (G).
 Multiplier Concept
• Analyze how a change in planned investment will
change the equilibrium level of output
• The change in equilibrium output will be greater
than the initial change in planned investment.
• Output changes by a multiple of the change in
planned investment.
• This multiple is called the investment multiplier
– the ratio of the change in the equilibrium level
of output to a change in some autonomous
variable
• A variable is autonomous when it is assumed not
to depend on the state of the economy
• Planned investment is assumed to be
autonomous.
 Multiplier Concept
• The Investment Multiplier = ∆Y / ∆I
= 1 / MPS
= 1 / 1- MPC
Where MPS = change in saving divided by
change in disposable income
MPC = change in consumption divided by
change in disposable income
MPC + MPS = 1
 Numerical Illustration
1. C = 100 + 0.75 Y and I = 25
Original Equilibrium Output = 500
2. Let Investment now increases by 25
The Investment Multiplier = 1 / 1 - 0.75
= 1 / 0.25 = 4
3. Increase in Y = Increase in I x Investment
Multiplier = 25 x 4 = 100
4. The new equilibrium Y = Original
equilibrium Y + Increase in Y
= 500 + 100 = 600
 Graphical Illustration
AE
Y = AE
AE1 = C + I1

AE = C + I

∆I = 25

∆Y = 100

500 600 Income (Y)

Revision of some Equations
with G and T
• Disposable income = Total income -
Net taxes
Yd = Y – T
•Y =C+S+T
Y- T = C + S
Yd = C + S
• AE = C + I + G
•C = a + b Yd
C = a + b (Y - T)
 Numerical Illustration
Question: Given: C = 200 + 0.6Yd
I = 60, G = 80, T = 100
Working: At Equilibrium,
Y = AE = C + I + G
Y = 200 + 0.6(Y - 100) + 60 + 80
Y = 340 + 0.6(Y - 100)
Y = 340 + 0.6Y - 60
Y - 0.6Y = 280
0.4Y = 280
Y = 280 / 0.4
Thus the equilibrium level of output is 700.
 Fiscal Policy at Work - The
Multiplier Effect
• The government uses its fiscal policy to change the
equilibrium level of output as well as the
unemployment rate and the inflation rate.
• Changes in government spending and taxes have a
multiplier effect on output and income.
• An increase in government spending has exactly the
same impact on the equilibrium level of output and
income as an increase in planned investment.
• A dollar of extra spending from either G or I is
identical with respect to its impact on equilibrium
output.
 Government Spending
Multiplier
• The formula for the government
spending multiplier is the same as the
formula for the investment multiplier.
• The government spending multiplier
(GSM)
= Change in equilibrium Y
Change in government spending
= 1 OR 1__
1-MPC MPS
 Numerical Illustration
Original Equilibrium Output is 700.
Calculate the new equilibrium output when
government spending increases by 100.
THE MULTIPLIER APPROACH
The GSM = 1/ MPS = 1/ 0.4 = 2.5
Increase in G = 100,
Increase in equilibrium Y = 100 x 2.5 = 250
New equilibrium Y = Original Equilibrium Y +
Increase in Y
= 700 + 250 = 950
Graphical Illustration
Aggregate Expenditure

C + I + G’

Increase in G by 100
C+I+G

700 950 Output/Income

Increase in Y by 250
 Tax Multiplier
The Tax multiplier ≠ government spending
multiplier
Change in G has a direct effect while change in
taxes is more indirect.
• A $1 increase in G will result in a $1 increase in
spending.
• A $1 decrease in T will result in less than a $1
of spending, depending on the MPC.
• Because the initial increase in planned AE is
smaller for a tax cut than it is for a government
spending increase, its final effect on the
equilibrium level of output and income will be
smaller
 Tax Multiplier
Tax multiplier (TM) = Change in equilibrium Y
Change in taxes
OR - MPC 1– 1__
MPS MPS

• The tax multiplier is a negative number

 Numerical Illustration
Original Equilibrium Output is 700.
Calculate the new equilibrium output when
government cuts taxes by 100.

THE TAX MULTIPLIER APPROACH

The TM = -MPC / MPS = -0.6 / 0.4 = -1.5
Decrease in T = -100,
Increase in equilibrium Y = -100 x -1.5 = 150
New equilibrium Y = Original Equilibrium Y +
Increase in Y
= 700 + 150 = 850
 Graphical Illustration

Aggregate Expenditure

C’ + I + G

Decrease in T by 100 (tax rebate)

C+I+G

Increase in Y by 150

700 850 Output/Income

 Balanced Budget Multiplier
• What if the government decides to pay for
its extra spending by increasing taxes by the
same amount?
• If G increases by $100m and this is
financed by a $100m increase in T (i.e. G =
+100 and T = +100)
•If MPC = 0.75, C will fall by $75m because
of the tax rises.
• Net effect on AE will be -$75m +$100m =
$25m
• Expenditure Multiplier = 1/0.25 = 4
• Output will therefore increase by $25m x 4
= $100m
Balanced Budget Multiplier
Balanced Budget Multiplier = GSM + TM
= 1 + -MPC
MPS MPS
= 1- MPC
MPS
= MPS
MPS
=1
 Balanced Budget Multiplier
• Ratio of the change in the equilibrium
level of output to a change in
government spending and a change in
taxes where the change in G and the
change in T must be in the same
direction as well as of the same
amount
• Is equal to one
• BBM = 1
 Reality Check
• The multiplier concept is still incomplete and
oversimplified. The multiplier effect is in reality
smaller.

• In reality, it is not so easy to raise government

spending.

• We have assumed that prices remain

unaffected. In reality, prices will rise as the
economy expands and this will reduce spending
and reduce the size of the multiplier
 Summary
Investment Multiplier _1__
MPS
Government Spending Multiplier __1__
(GSM) MPS

Tax Multiplier (TM) -MPC

MPS

Balanced Budget Multiplier (BBM) 1

The Government Budget
Three types of government budget
• Balanced Budget where G = T
• Budget Deficit where G > T
• Budget Surplus where G < T
 National income and the size of the
public--sector deficit or surplus
public
G, T

Tax revenue

SURPLUS

DEFICIT Gov. expenditure

(incl. benefits)
O Y1
Y
 National income and the size of the
public--sector deficit or surplus
public
• The tax revenue function is upward
sloping since the higher the income, the
greater the tax rate imposed.
• The government expenditure is
downward sloping, showing that at
higher income; less is paid out in
welfare and unemployment benefits.
• Equilibrium is at Y1.
• Below Y1, there is a deficit. Above Y1,
there is a surplus.
 FISCAL POLICY
• Automatic fiscal stabilisers: G or T that takes place
without any deliberate fiscal policy decisions. They
automatically expand during recessions and contract
during boom period.
– tax stabilisers: in a recession, wages fall and tax
revenues fall. Households move into lower tax
brackets. Dampen the fall in after-tax income.
– benefits stabilisers: Increased welfare payments
and unemployment benefits in a recession limit the
decline of C by replacing some of the incomes lost.
 FISCAL POLICY
• Discretionary fiscal policy
– changing government expenditure and taxation
to eliminate inflationary and deflationary gaps.
– Increase G and lower T to close a deflationary
gap.
– Decrease G and raise T to close an inflationary
gap.
 FISCAL POLICY
• Discretionary fiscal policy: problems of timing and
time lags

– various time lags (recognition lag, implementation

lag, result lag)

– The intention is to progress from path a to path b

in a typical business cycle but the outcome that is
hampered by lags could be path c.

– policy may be destabilising

 Fiscal policy: stabilising or
destabilising?
Path (a): no intervention
Path (b): policy stabilises
3
Real national income

4
3
2
4

2 1

1
Path (c): policy destabilises

O
Time
 Tutorial question 1
• The following table shows part of a country’s
national expenditure schedule (in £ billions).
National 100 120 140 160 180 200 220
income (Y)
National 115 130 145 160 175 190 205
expenditure (E)

(a) What is the government expenditure multiplier?

(b) What is the tax multiplier?
Assume that full employment is achieved at a level of national
income of £200 billion.
(c) Is there an inflationary or a deflationary gap, and what is its
size?
 Tutorial question 1 (ct’d)
(d) By how much would government expenditure have
to be changed in order to close this gap (assuming no
shift in other injections or withdrawals)?
(e) Alternatively, by how much would taxes have to be
changed in order to close the gap (again assuming no
shift in other injections or withdrawals)?
(f) Alternatively, assuming that there were initially a
balanced budget, and that the government wanted to
maintain a balanced budget, by how much would both
government expenditure and taxes have to be changed
in order to close the gap?
 Tutorial question 2
• What are the problems of relying on automatic
fiscal stabilisers to ensure a stable economy at
full employment?
 Tutorial question 3

• Provide examples of automatic stabilisers.

Explain how they work.
 Tutorial question 4
• Assume that the government increases both
government spending and taxes by 40 million.
Find the change in a country’s output.
 Tutorial question 5
• The government is considering two alternative
policies, one involving increased government
purchases of 50 units, the other involving a tax
cut of 50 units. Which policy will stimulate
aggregate expenditure by more?
 Tutorial question 6
• Discuss possible reasons why the use of fiscal
policy to stabilise the economy is more
complicated than suggested by the Keynesian
model?
End of Unit 9