FISCAL POLICY

The Multiplier
1
𝑌= . 𝐶0 +𝐼0 +𝐺0 + 𝑋0 − 𝑀0 − 𝑀𝑃𝐶. 𝑇0
1 − 𝑀𝑃𝐶. 1 − 𝑡 − 𝑀𝑃𝐼 + 𝑀𝑃𝑀
= 𝑘. 𝐴

➢The Multiplier is the amount by which a change in autonomous

expenditure is magnified or multiplied to determine the change in

equilibrium expenditure.

∆𝑌
𝑘=
∆𝐴
The Multiplier
• Other multipliers

𝐴 = 𝐶0 + 𝐼0 + 𝐺0 + 𝑋0 − 𝑀0 − 𝑀𝑃𝐶. 𝑇0
⇒ ∆𝐴 = ∆𝐶0 + ∆𝐼0 + ∆𝐺0 + ∆𝑋0 − ∆𝑀0 − 𝑀𝑃𝐶. ∆𝑇0

∆𝑌
𝑘𝐶 = =𝑘
∆𝐶0

∆𝑌
𝑘𝐼 = =𝑘
∆𝐼0

∆𝑌
𝑘𝐺 = =𝑘
∆𝐺0
The Multiplier
• Other multipliers

𝐴 = 𝐶0 + 𝐼0 + 𝐺0 + 𝑋0 − 𝑀0 − 𝑀𝑃𝐶. 𝑇0
⇒ ∆𝐴 = ∆𝐶0 + ∆𝐼0 + ∆𝐺0 + ∆𝑋0 − ∆𝑀0 − 𝑀𝑃𝐶. ∆𝑇0

∆𝑌
𝑘𝑋 = =𝑘
∆𝑋0

∆𝑌
𝑘𝑀 = = −𝑘
∆𝑀0

∆𝑌
𝑘𝑇 = = −𝑀𝑃𝐶. 𝑘
∆𝑇0
The Multiplier
• Balanced budget multiplier: 𝑘𝐵

∆𝑌 = 𝑘𝐺 . ∆𝐺0 + 𝑘 𝑇 . ∆𝑇0
𝐴𝑠 ∆𝐺0 = ∆𝑇0
⇒ ∆𝑌 = 𝑘𝐺 + 𝑘 𝑇 . ∆𝐺0 = 𝑘𝐺 + 𝑘 𝑇 . ∆𝑇0
= 𝑘𝐵 . ∆𝐺0 = 𝑘𝐵 . ∆𝑇0
𝒌𝑩 = 𝒌𝑮 + 𝒌𝑻
= 𝑘 − 𝑀𝑃𝐶. 𝑘
= 1 − 𝑀𝑃𝐶 . 𝑘
Fiscal Policy
• Fiscal policy: the setting of the level of government spending and

taxation by government policymakers. → to achieve

macroeconomic objectives such as full employment, sustained
economic growth, and price level stability.
Fiscal Policy
Expansionary fiscal policy Contractionary fiscal policy
• Objective: increase aggregate • Objective: decrease aggregate
demand, aggregate expenditure demand, aggregate expenditure
• Use when: • Use when:
➢ Low aggregate demand ➢ Overheated economy
➢ High unemployment ➢ Economic bubble
➢ Deflation ➢ High inflation
➢ Recession • Tools:
• Tools: ➢↓ G
➢↑ G ➢↑ T
➢↓ T ➢ ↓ G and ↑ T
➢ ↑ G and ↓ T
Fiscal Policy
Automatic stabilizers
• Automatic stabilizers:

➢Tax system

➢Unemployment-insurance and welfare systems

→ Stimulate or depress the economy when necessary without any

deliberate policy change.
Fiscal Policy
Disadvantages
• There is insufficient information about the value of key parameters.

• Implementation of Expansionary fiscal policy is much easier than that of

Contractionary fiscal policy.
• Time lags:

➢Inside lag: the time between a shock to the economy and the policy
action responding to that shock.
➢Outside lag: the time between a policy action and its influence on the
economy.
Fiscal Policy

1
𝑌= . 𝐶0 +𝐼0 +𝐺0 + 𝑋0 − 𝑀0 − 𝑀𝑃𝐶. 𝑇0
1 − 𝑀𝑃𝐶. 1 − 𝑡 − 𝑀𝑃𝐼 + 𝑀𝑃𝑀

• Change G, T (𝐺0 , 𝑇0 , 𝑡) → Y changes

• Objective: to achieve potential output 𝑌𝑝

∆𝑌 = 𝑌𝑝 − 𝑌
Fiscal Policy
• Change G:

∆𝑌
𝑘𝐺 = =𝑘
∆𝐺0

∆𝑌 ∆𝑌
⇒ ∆𝐺 = ∆𝐺0 = =
𝑘𝐺 𝑘
 G↑
AE
450
AE1
E1
AE
E

A + ∆G

0 Y
Y Yp
12
Fiscal Policy
• Change T0:

∆𝑌
𝑘𝑇 = = −𝑀𝑃𝐶. 𝑘
∆𝑇0

∆𝑌 ∆𝑌
⇒ ∆𝑇0 = =
𝑘 𝑇 −𝑀𝑃𝐶. 𝑘
Fiscal Policy
• Change 𝑡 :

➢Plug in Yp for Y:

1
𝑌= . 𝐶0 +𝐼0 +𝐺0 + 𝑋0 − 𝑀0 − 𝑀𝑃𝐶. 𝑇0
1 − 𝑀𝑃𝐶. 1 − 𝑡 − 𝑀𝑃𝐼 + 𝑀𝑃𝑀

And let 𝑡 be a variable, solve for 𝑡

Fiscal Policy
• If both G and T are used:

∆𝐴 = ∆𝐺0 − 𝑀𝑃𝐶. ∆𝑇0

Fiscal Policy and Government budget
• Government budget balance:

𝐵 =𝑇−𝐺

➢𝐵 = 0: a balanced budget

➢𝐵 > 0: a government budget surplus

➢𝐵 < 0: a government budget deficit

Exercise 2
• Consider a closed economy with government, autonomous tax. Marginal
propensity to consume is 0.8. Potential output is $1200 billion. Currently,
the equilibrium output is $1000 billion. To achieve the potential output
(ceteris paribus):
a. How much should government purchases be changed?
b. How much should tax be changed?
c. How much should tax and government purchases be changed to
keep the government budget unaffected?
Exercise 3
• Consider a closed economy. Marginal propensity to consume is 0.8 and

tax rate is 1/3. Both autonomous consumption and investment are $100
billion and government purchases are $500 billion.

a. What is the consumption function?

b. What is the aggregate expenditure function?

c. Calculate the equilibrium output.

d. What happens to the government budget at the equilibrium output?

Exercise 3

• Now suppose that government purchases are decreased to $200

billion and tax rate is 1/6.

e. What is the new consumption function?

f. What is the new aggregate expenditure function?

g. Calculate the new equilibrium output.

h. Calculate tax. What happens to the government budget at the

new equilibrium output?

Exercise 4
• Consider a closed economy. Marginal propensity to consume is 0.9 and

tax rate is 1/6. Autonomous consumption is $5 billion, investment is $15

billion, and government purchases are $40 billion.

a. What is the consumption function?

b. What is the aggregate expenditure function?

c. Calculate the equilibrium output.

d. What happens to the government budget at the equilibrium output?

Exercise 4

• Now suppose government purchases are increased to $120 billion

and tax rate is 3/8.

e. What is the new consumption function?

f. What is the new aggregate expenditure function?

g. Calculate the new equilibrium output.

h. Calculate tax. What happens to the government budget at the

new equilibrium output?

Exercise 5
• In a closed economy: autonomous consumption is 400, autonomous
investment is 450, government purchases are 300, autonomous tax is
400, marginal propensity to consume is 0.75, tax rate is 0, marginal
propensity to invest is 0.
a. If output is 4200, how much is consumption?
b. If output is 4200, how much is saving?
c. Is the economy in equilibrium at the output of 4200? If not, what is
the equilibrium output?
 Exercise 6
• In a closed economy:

𝐶 = 45 + 0,75𝑌𝑑
𝐼 = 60 + 0,15𝑌 𝐺 = 90
𝑇 = 40 + 0,2𝑌
𝑌𝑝 = 740
a. Calculate the equilibrium output. How is the current government budget?
b. Suppose government purchases are increased by 10. Calculate the new equilibrium
output. How much more tax does the government collect?
c. From the above result, to achieve potential output, how should the fiscal policy be
implemented in each situation below:
i. Only G is used
ii. Only T is used
 Exercise 7
• In an open economy:

𝐶0 = 300, 𝐼0 = 400, 𝐺 = 500, 𝑇0 = 200, 𝑋0 = 500, 𝑀0 = 100

𝐶𝑚 = 0,5 𝑇𝑚 = 0,3 𝐼𝑚 = 0 𝑀𝑚 = 0,1

a. Calculate the equilibrium output, consumption, saving, and tax.

b. At the equilibrium output, how is the government budget?

c. At the equilibrium output, how is the balance of trade?

d. If government purchases are increased by 30, what is the new equilibrium output?
How much more tax does the government collect?
 Exercise 8
• In an open economy:

𝐶 = 200 + 0,75𝑌𝑑
𝐼 = 100 + 0,2𝑌 𝐺 = 580
𝑇 = 40 + 0,2𝑌
𝑋 = 350
𝑀 = 200 + 0,05𝑌
𝑌𝑝 = 4400
a. Calculate the equilibrium output. How are the government budget and the balance of trade?
b. Government purchases are increased by 70. Calculate the new equilibrium output.
c. From the above result, to achieve potential output, how should the government change its tax?
 Exercise 9
• In an open economy:

𝐶 = 150 + 0,8𝑌𝑑
𝐼 = 50 + 0,1𝑌
𝑇 = 40 + 0,1𝑌
𝑋 = 200
𝑀 = 40 + 0,12𝑌
𝑌𝑝 = 2000
a. Calculate the equilibrium output when balancing the government budget.
Calculate government purchases.
b. How is the balance of trade?