ECON6049 ECONOMIC ANALYSIS, S1 2021

Week 10: Unit14 – Unemployment and Fiscal Policy

(Part B)
OUTLINE
A. The multiplier model with all sectors
B. The role of Government in Stabilising the
Economy and Fiscal Policy
C. Government Budget & Debt
A. THE MULTIPLIER MODEL :
ALL SECTORS
 Four-sector model: AD = C + I + G + NX
(i) Consumption: C =c0 + c1 (1-t)Y
t: tax rate
(1-t)Y = Disposable income
(ii) Investment: I = I(r)
• Ceteris paribus, a higher interest rate reduces investment spending, shifting
down the aggregate demand curve.
• In addition, a higher expected post-tax rate of profit raises investment spending,
shifting up the aggregate demand curve.
(iii) Government: Government spending is exogenous or autonomous G = G
Government Tax Revenue (T) = tY where t is the marginal tax rate on income.
Therefore, t = ΔT/ΔY. Assume that 0<t<1
Four-sector model: AD = C + I + G + NX
(iv) Net Exports = NX = exports - imports
• The amount of exports is taken as exogenous or autonomous.
X=X
• The amount of imports depends on domestic income.
• Marginal propensity to import (m) = The fraction of each additional
unit of income that is spent on imports. Assume 0<m<1
• Therefore, import spending: (M) = mY  NX = X - mY
m = ΔM/ΔY
 Four-sector model: AD = C + I + G + NX
AD = c0 + c1(1 – t)Y + I(r) + G + X – mY
= [c0 + I(r) + G + X] + [c1(1 – t) – m]Y
When Y = 0 → AD = c0 + I(r) + G + X and this is the vertical axis intercept
• An ↑ in c0 , or I, or G, or X will cause the vertical intercept to increase and the AD
curve to undergo an upward parallel shift.
• A ↓ Δc0 , or I, or G, or X will cause the vertical intercept to decrease and the AD curve
to undergo a downward parallel shift.
Slope of AD = ΔAD/ΔY
ΔY = +1 → ΔAD = [c1(1 – t) – m]*ΔY = [c1(1 – t) – m]
• Therefore,
- If ↑c1, or ↓t, or ↓m → AD gets steeper
- If ↓ c1, or ↑t, or ↑m → AD gets flatter
Four-sector model: the Multiplier
 𝟏
AD = c0 + c1(1 - t)Y + I(r) + G + X – mY & Y* = 𝟎
𝟏 𝒄𝟏 𝟏 𝒕 𝒎
Aggregate
demand, AD Y = AD on 45
degree line

Y1
B
AD = [c0 + I(r) + G + X] + [c1(1 – t) – m]Y
Slope = [c1(1 – t) – m] AD1
A
When Y = Y* the economy is in equilibrium
and Y = AD → firms con nuing to produce Y*
AD2
When Y = Y1 the economy is in disequilibrium
and Y > AD → firms will↓ produc on
c0 + I(r) + G + X
When Y = Y2 the economy is in disequilibrium
and Y < AD → firms will↑ produc on
Y2 C

45°

Y2 Y* Y1 Output (income), Y
 THE MULTIPLIER: ALL SECTORS
𝟏
Equilibrium Income: Y = 𝟎
𝟏 𝒄𝟏 𝟏 𝒕 𝒎
𝟏
Multiplier =
𝟏 𝒄𝟏 𝟏 𝒕 𝒎

• Decrease in the MPC, or an increase in the tax rate, or an increase in marginal

propensity to import reduce the size of the multiplier  flatter AD curve.
• Increase in the MPC, or a decrease in the tax rate, or a decrease in marginal
propensity to import increase the size of the multiplier  steeper AD curve.
Covid-19 Shocks to AD are amplified by the Multiplier
Aggregate
demand, AD Y = AD on 45
degree line

AD

AD(lower level of
consumption, c0′)

c0 + I(r) + G + X Δc0
B Multiplier =ΔY/ Δc0
ΔY > Δc0
Multiplier amplifies the
c0′ + I(r) + G + X ΔY effect of the original
change in autonomous
spending
45°
Output (income), Y
B. THE ROLE OF GOVERNMENT IN STABILISING
THE ECONOMY & FISCAL POLICY
 STABILISING THE ECONOMY
• Government spending and taxation can stabilize economic fluctuations.
 Government spending is large and exogenous and fluctuates much less than
consumption and investment.
 Higher tax rate lowers the multiplier so fluctuations in GDP are smaller
• Government transfer such as Unemployment benefit schemes help households
smooth consumption.
• Unemployment benefit schemes and proportional tax rate are automatic
stabilizers. That means they automatically offset an expansion or contraction
of the economy.
• A tax system that makes tax revenue a function of GDP is an example of an
automatic stabilizer. So that when the economy is contracting the government
reduces the amount of tax it takes when the economy can least afford it and takes
more tax when it can during an expansion.
 FISCAL POLICY
• Fiscal policy: Changes in taxes or government spending to achieve economic
objectives.
• When fiscal policy is designed to offset changes in private sector spending in
order to stabilize the economy it is called stabilization policy or counter-cyclical
policy.
– Expansionary fiscal policy (decreasing taxes and/or increasing spending)
https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19#I
– Contractionary fiscal policy (decreasing G and/or increasing taxes)
• Fiscal policy doesn’t happen automatically, and requires political action &
decision making which can be cumbersome. Monetary policy is much easier to
change (the interest rate)
 Economic contraction and Fiscal Policy
• During an economic contraction, such as the GFC and the pandemic in 2020,
the economy has been operating well below capacity utilization.
• The household sector is unlikely to lead the recovery because expected broad
wealth is likely to have fallen below the target broad wealth triggering an
increase in precautionary saving and a decline in consumption.
• Firms are unlikely to lead the recovery because they are operating well below
capacity so there is no incentive to increase investment spending.
• If the contraction is global then an export-led recovery is unlikely.
• This leaves the government sector as the only sector that can stimulate
spending in the economy! Therefore, fiscal policy has a key role to play.
 FISCAL STIMULUS
Government can counteract the fall in
AD from the private sector via fiscal
stimulus:
• Cut taxes to encourage the private
sector to spend more
• Increase spending (G), which
directly increases AD
• The rise in G operates via the
multiplier, so the increase in Y will
typically be greater than the increase
in G.
FISCAL POLICY & REST OF THE WORLD
1. Fluctuations in the growth rate of important markets abroad influence
the domestic economy via demand for exports.
2. Demand for imports reduces domestic fluctuations.
3. Foreign trade limits the use of fiscal stimulus if the marginal propensity
to import is large.
“The significant fiscal stimulus in the United States, along with faster
vaccination, could boost US GDP growth by over 3 percentage points this
year, with welcome demand spillovers in key trading partners.”
OECD Economic Outlook Report, March 2021
 LIMITATIONS OF FISCAL POLICY
• To be useful, discretionary changes in fiscal policy need to be timely - no
point increasing G just when a recession is over.
• In practice changing government spending or taxes involves a lengthy
legislative process (in Australia, Budget needs to be passed by both House of
Representatives and Senate). This can mean that when discretionary changes
are introduced they may no longer be required and may even destabilize the
economy.
• Most decisions on fiscal policy are only made annually in the Budget ( in
Australia, Federal Budget is in May). Then it takes time to implement the
decisions.
• Macroeconomic policy should be forward-looking e.g. fiscal policy changes
today should be designed to influence future (forecast) levels of output.
 THE PARADOX OF THRIFT
• In a recession a family worried about their falling wealth cuts spending and
saves more because of the falling value of shares and houses, and also
because rising unemployment reduces expected future earnings from
employment
• But in the economy as a whole, spending and earning go together.
• Fallacy of composition: What is true for one part of the economy (a single
household or firm) is not true of the whole economy.
• The paradox of thrift = the aggregate attempt to increase savings leads to a fall in
aggregate income.
• In other words, an attempt by the household sector as a whole to cope with an
economic contraction by increasing precautionary savings, actually worsens the
economic contraction and may under certain conditions in fact reduce aggregate
saving.
C. GOVERNMENT BUDGET & DEBT
 GOVERNMENT BUDGET
• Budget outcome = T – G = tY – G (In the 4-sector multiplier model)
• A government’s budget position is typically measured on an annual basis.
• Balanced Budget = T – G = 0
• The logic is that budget is surplus in good times/expansions, deficits in bad
times/contractions, hence budget in balance over the business cycle.
• Budget surplus = T – G > 0
• Budget deficit = T – G < 0 (Fiscal stimulus can result in a negative budget balance)
• A government can fund the deficit in 3 ways:
• Taxes
• Borrowing (i.e. it can sell government securities---bonds)
• Printing Money (this approach has bad reputation – associated with
hyperinflation - monthly inflation greater than 50%)
 GOVERNMENT DEBT
• Government debt = sum of all the bonds sold over time to finance budget deficit –
matured bonds (repaid debt). A large stock of debt relative to GDP can be a problem
because the government has to pay interest on its debt.
• An ever-increasing debt ratio is unsustainable, but there is no rule that says exactly
how much debt is problematic.
• However, there is no point at which the government has to pay off all its stock of
debt—it can roll it over instead by issuing new bonds.
Sovereign debt crisis
• A situation in which government bonds come to be considered so risky
that the government may not be able to continue to borrow. If so, the
government cannot spend more than the tax revenue they receive.
• Some Eurozone countries (Greece, Italy, Ireland, Spain, Portugal) during
the GFC had trouble financing their debt. Interest rates on bonds
increased to critical levels. The EU provided loans to these countries on
conditions that they had to fix budgetary problems (i.e., austerity
policies) via increase taxes & cut spending →massive protests.
 Why Government Debt matters
• Debt is costly as governments must make periodical coupon payment to
creditors. Raising interest rates would weaken debt serviceable and deteriorate
deb sustainability.
• Inhibit growth by steering resources into debt service instead of productive
investment.
• Limit policy choices and reduce the effectiveness of fiscal policy.
• Possible crowding out of private sector investment:
• Excessive government debt might eventually cause interest rates to rise and
crowd out private investment.
• Deterioration in government debt position might affect the government’s
creditworthiness and vibrate across the financial system.
• Finally high levels of debt might lead to financial crises!