SESSION 5

FISCAL POLICY: MANAGING AGGREGATE DEMAND

Before 1930s Great depression, the hands-off attitude was implied later after the depression John
Keynes argued that economic fluctuations were not self-correction

Government taxing and spending decision could moderate the business cycle and increase the
aggregate demand

Four Concepts

 how aggregate supply adjusts to the level of aggregate demand

 consumption function to help understand how aggregate demand
 income multiplier
 the government sector and discuss how government fiscal policy can be used to manage
aggregate demand

Aggregate Supply and Demand

 Two participants: Consumer and producer

 The economy is said to be in equilibrium if the total
amount of goods and services produced is equal to the
total amount of goods and services demanded.
 Aggregate demand fixed at 10, sales will be less at point
A and output and inventory increase, contrary for point
B
 At b, AD> Y, people are demanding more products and
economy is not able service their needs, signal to
market to produce more. Output would increase
 The equilibrium is AD=Y
 At point A, AD<Y, people are demanding less, output is high and AD is low. The inventory would
start to pile up. Slow down the production then it will have contraction and move to Equilibrium.
Govt would take steps to move the Output curve inwards to equilibrium.

Consumption: Determine the aggregate demands

 Personal consumption are greatest cut of aggregate demand

 Assuming investment, government spending, and foreign trade are all zero.
 Consumption increase with income levels

C=C+cY

In equation (1), C represents the level of consumption and Y represents income. C is the level of
consumption when income is zero (financed by borrowing, drawing down savings or transfer
payments). C is the amount that consumption increases with each additional dollar of income—a
ratio called the marginal propensity to consume (MPC).

(1-c)= Savings (Marginal propensity to save)

 Multiplier effect:

To summarize, an autonomous increase in demand is multiplied because it cycles through the

economy again and again. The multiplier increases with the marginal propensity to consume and
decreases with leakages.

 Government spending= 1/ MPS

 Tax multiplier= -(MPC/MPS)
 Balanced Budget multiplier= 1 (Whatever gov is collecting is spending so nullify impact)
 High multiplier is having economy with a spare capacity (high unemployment), high
consumption.

ANIMAL SPRIT: INVESTMENT is at center of business cycle, because of optimisim if there is expectation
in economy in a negative way, the negative multiplier effect takes place.

Adjustment back toward the equilibrium level might be slow because of sticky wages and prices? Does
adjustment happen fast enough to take the needed step to get the economy back at full employment?
Who do we deduce when to take the right action in case of government to reduce taxes in order to
increase consumption and other factors?

When businesspeople respond to temporary fluctuations in output by dramatically revising their views
of the future, investment plummets, suppressing aggregate demand, and setting off a negative
multiplier process.

Insufficient demand means unemployment, idle capacity, and lost production. Excessive demand means
inflation—general increases in prices and money incomes, bringing forth little or no gains in output and
real income. The objective of stabilization policies is to minimize these deviations, i.e. to keep overall
demand in step with the basic production potential of the economy.

VIDEO SESSION

Objectives

 Macro-economic stabilization is the primary objectives (employment,, output and stable prices
for exchange rates and interest rates): Less oscillation in the movements
 Low inflation rate
 Efficiency in resource allocation
 Provision of public goods (Externality, market failures and public private partnership (private
schools)). Private goods are purely meant for individual use, public good are for the collective
use. Public goods for welfare (Climate and National Defense). We all individually contribute less
incentive to maintain level of provisioning and availability of the goods through taxation.
(Excludability principle and degree of rivalry). Everyone wants it but one wants to contribute

Government income is taxes, and expenditure. Gov Resources (Net Taxes, transfer payments)

Income = T= T+tY (T= Fixed taxes, t is percentage of income/gdp)

 Expense= G=G+gY (G= autonomous expense (defense), g is percentage of income/gdp)

G>T= Budget Surplus (Austerity), G<T= Deficit (Expansionary), G=T= Balanced budget

Through budget we can see the fiscal policy of the government

Fiscal Instrument

Taxes

 Direct Taxes (income and wealth)

 Indirect taxes (GST and Tariffs)
 Subsidies (create consumption and production for certain products, i.e. fertilizers for CA bc we
will have to import products and would need dollars for that)

Spendings

 Pure Public Goods (Defense and roads)

 Semi-public Goods (Education, and Health)

Debt
 Borrowing from the private sector- Crowding out
 From the central banks- Inflationary tax

SESSION 2

 Disposable earnings after taxes

Y= Y-t
 Marginal propensity= how many
cents out of 1 rupee
 Aggregate spending= AE= C+I+G
 Equilibrium when Y=AE
 When Y=AE then economy is in
equilibrium, when AE>Y or Y>AE
then its discrepancy, which will
be resolved with the help of fiscal
policy.
When the Y is -150, the GDP should increase, because it is telling us that there were more demand for
the products and production is currently slow, signal to the economy to produce more and the output
will increase.

At Equilibrium they should stop producing goods or the inventory would pile they would reduce the
production and economy will go into contraction.

HOW GOVT can affect the AD?

 Increase taxes and reduce Yd, and can impact the AD and people will spend less. AD will reduce
AE has reduced, when the economy is operating beyond the full employment
 Reducing taxes so consumption increase, the output will increase and economy will move from
recession to equilibrium.
 T<G, increase spending will increase the income of the people, people will spend more and
economy will move towards E.
 T>G, more revenue spending less in that case income levels will reduce, they will spend less the
aggregate demand will fall. Inventory pill up, the production slows down then output will move
inward to E.
MULTIPLIER EFFECT

The income multiplier is 2.5x, the change of 100 dollar contributed 250 to the economy.
The change of 25 and investment created an impact and increased the total income by 100 dollars.

Investment, export proceeding, government spending

FISCAL POLICY MULTIPLYER

Change in 50 billion caused income to jump from 900 to 1100

Change in income through change in taxation less consumption over marginal propensity to save.

If taxes increase 10%, income reduced by 30%. Negative correlation between taxes in income and
consumption.

Automatic Stablizers

Progressive taxation (Wrachted effect)

Drawback and limitation of fiscal policy

 Recognition lag
 Decision lag
 Implementation lag
 Impact lag
 Difficult in changing tax policies
 Regional variations
 Conflict between levels of government
 Size of debt
 Crowding out of private sector
 Deficit redistribution of wealth
 Deficit impose net burden on next generations

Pakistan’s debt according to sbp 103% of total GDP

External (commercial, bilateral, multilateral) and domestic

Sustainability as debt percentage of GDP, Debt to export, Debt to reserves

Rating agencies role