Chapter 4: Fiscal policy

Hong Ngoc Bui, M.Sc.

Faculty of Economics, UEL
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Content

4.1. Discretionary fiscal policy

4.2. Automatic stabilizer
4.3. Trade policy
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4.2. Discretionary fiscal policy

• Fiscal policy is the way government in which the government determines
the revenues and expenditures that affect economic activity.
• Method:

Change T and G Change AD Change Y, U, P

• Target: Stability
• 2 types: subjective fiscal policy and autonomic fiscal policy
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4.1. Discretionary fiscal policy

Expansionary fiscal policy

How to apply: ↑ 𝐺 and/or ↓ 𝑇
Applied when recession economy
DISCRETIONARY
FISCAL POLICY
Contractionary fiscal policy
How to apply: ↓ 𝐺 and/or ↑ 𝑇
Applied when over-heated economy
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Mechanism of impact of fiscal policy

𝑌𝐸 < 𝑌𝑃 In order to 𝑌𝐸 = How to apply

𝑌𝑃

• Recession • Use • 𝑇𝑥 ↓, 𝑇𝑟 ↑ ⇒
economy expansionary 𝑇 ↓ ⇒ 𝑌𝑑 ↑ ⇒
fiscal policy 𝐶 ↑ ⇒ 𝐴𝐷 ↑
⇒ 𝑌𝐸 ↑
• 𝐺 ↑ ⇒ 𝐴𝐷 ↑
⇒ 𝑌𝐸 ↑
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Mechanism of impact of fiscal policy

𝑌𝐸 > 𝑌𝑃 In order to 𝑌𝐸 = How to apply

𝑌𝑃

• Over-heated • Use • 𝑇𝑥 ↑, 𝑇𝑟 ↓ ⇒
economy contractionary 𝑇 ↑ ⇒ 𝑌𝑑 ↓
fiscal policy ⇒𝐶 ↓⇒
𝐴𝐷 ↓ ⇒ 𝑌𝐸 ↓
• 𝐺 ↓ ⇒ 𝐴𝐷 ↓
⇒ 𝑌𝐸 ↓
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Quantitate for fiscal policy
Target 1: Change G and T to bring the economy to
potential output
Suppose the initial output is Y1 < Yp => ∆𝑌 = 𝑌𝑝 − 𝑌1
AD
To increase Y1 to Yp, it is necessary to change AD 1
AD2
amount ∆𝐴𝐷:
∆𝑌
∆𝑌 = 𝑘. ∆𝐴𝐷0 or ∆𝐴𝐷0 = ∆𝐴𝐷0 AD1
𝑘 𝐴𝐷02
where:
1 1 𝐴𝐷01
𝑘= =
1 − 𝐶𝑚 1 − 𝑇𝑚 − 𝐼𝑚 + 𝑀𝑚 1 − 𝐴𝑚
∆𝑌
450
Y1 Yp Y
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Quantitate for fiscal policy

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Target 1: Change G and T to bring the economy to

potential output
• Case 1: Change G
∆𝐺 = ∆𝐴𝐷0𝐺
• Case 2: Change T
∆𝑌𝑑 = − ∆𝑇
⇒ The increase in consumption: ∆𝐶 = 𝐶𝑚. ∆𝑌𝑑 = −𝐶𝑚. ∆𝑇
∆𝐴𝐷0𝐶
⇒ ∆𝐴𝐷0𝐶 = ∆𝐶 = −𝐶𝑚. ∆𝑇 ⇒ ∆𝑇 = −
𝐶𝑚
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Quantitate for fiscal policy
Target 1: Change G and T to bring the economy to
potential output
• Case 3: Change both G and T
Suppose ∆𝐴𝐷0𝐺 is the increase of AD caused by the change in G
∆𝐴𝐷0𝐶 is the increase of AD caused by the change in T
∆𝐴𝐷0𝐶
∆𝐺 = ∆𝐴𝐷0𝐺 ∆𝑇 = −
𝐶𝑚
We have: ∆𝐴𝐷0𝐺 + ∆𝐴𝐷0𝐶 = ∆𝐴𝐷0
∆𝐺 + −𝐶𝑚. ∆𝑇 = ∆𝐴𝐷0
∆𝐺 − 𝐶𝑚. ∆𝑇 = ∆𝐴𝐷0
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Example 1

Given that the initial equilibrium output Y1 = 1000; potential

output Yp = 1180; marginal consumption Cm = 0.75;
multiplier k = 3. The economy is in recession. What types of
fiscal policy can the government conduct?
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Quantitate for the fiscal policy

Target 2: change T so that aggregate demand remains
constant while government changes G
• When the economy is at potential output Yp and the government
increases G.
• To prevent the increase of inflation, government needs to increase tax to
reduce consumption.
• The change of consumption upon the increase of tax:
∆𝐶 = 𝐶𝑚. ∆𝑌𝑑 = −𝐶𝑚. ∆𝑇
• To let output remain at Yp the decrease in C must be equal to the increase
in G
∆𝐺
⇒ ∆𝐶 = −∆𝐺  −𝐶𝑚. ∆𝑇 = −∆𝐺 ⇒ ∆𝑇 =
𝐶𝑚
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4.2. Automatic stabilizer

• The automatic stabilizing factor is a factor that by itself has the
effect of limiting the business cycle.
• Factors such as progressive income taxes, subsidies and
unemployment benefit, etc. are considered as automatic
stabilizers, which have the effect of preventing fluctuations in
output.
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4.2. Automatic stabilizer

• Progressive tax: a tax levied on the rich more heavily than on the poor.
• The partially progressive tariff in Vietnam:

Income tax/month
0-5 > 5 - 10 > 10 - 18 > 18 - 32
(million dong)
Tax 5% 10% 15% 20%
Source: Circular 111/2013/TT-BTC dated 15/8/2013.
• Example: Income = 12 million dong/month ⇒ tax payment = 1,050,000 ⇒
𝑌𝑑 = 10,950,000
• Income = 9,000,000 ⇒ tax payment = 650,000 ⇒ Yd = 8,350,000
⇒ Income reduces 25%, tax reduces 38%, Yd reduces 23.7%.
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4.2. Automatic stabilizer

• Unemployment benefit
• When the economy is in recession ⇒ unemployment increases
• If there is no unemployment benefit ⇒ consumption decreases
⇒ the recession worsens
• If there is unemployment benefit ⇒ consumption does not decrease
significantly ⇒ the recession is reduced
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4.3. Trade policy

• Trade policy is mainly aimed at limiting imports and
increasing exports.
• Mainly going in the direction of expansion, not contraction.
• Change of export and import affect 𝑌𝐸 and NX.
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4.3. Trade policy Increase in export

AD 𝐴𝐷2
Increase export an amount ∆𝑋
• Impact on output 𝐴𝐷1
Aggregate demand: ∆𝐴𝐷0𝑋 = ∆𝑋
 ∆𝑌 = 𝑘. ∆𝐴𝐷0𝑋 = 𝑘. ∆𝑋
• Impact on trade balance
𝑋 ↑⇒ 𝑌 ↑⇒ 𝑀 ↑
𝑀 = 𝑀𝑜 + 𝑀𝑚. 𝑌
∆𝑌
𝑌 ↑ ⇒ ∆𝑀 = 𝑀𝑚. ∆𝑌 = 𝑀𝑚. 𝑘. ∆𝑋 450
𝑌1 𝑌2 Y
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4.3. Trade policy Increase in export

M
X, M
𝑋2

𝑋1
• Case 1: 𝑀𝑚. 𝑘 < 1∆𝑀 < ∆𝑋

Y
Trade balance has tendency to
AD
𝑌1 𝑌2
𝐴𝐷2
surplus
• Case 2: 𝑀𝑚. 𝑘 > 1∆𝑀 > ∆𝑋
𝐴𝐷1
Trade balance has tendency to
deficit
• Case 3: 𝑀𝑚. 𝑘 = 1∆𝑀 = ∆𝑋

∆𝒀
Trade balance does not change
450
𝑌1 𝑌2 Y
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4.3. Trade policy Increase in export

• The policy of increasing exports only helps to improve the

balance of trade when 𝑀𝑚. 𝑘 < 1.
• 𝑀𝑚. 𝑘 < 1 is always true when the investment function has the
form 𝐼 = 𝐼𝑜
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Example 2
Given the following functions:
• 𝐶 = 100 + 0,75𝑌𝑑 𝐼 = 50 + 0,05𝑌 𝐺 = 300
• 𝑇 = 40 + 0,2𝑌 𝑀 = 70 + 0,15𝑌 𝑋 = 150
a. Calculate the equilibrium output.
b. Give your opinion about the trade balance at equilibrium
output.
c. Suppose export increases an amount ∆𝑋 = 100, what happens
to the trade balance?
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4.3. Trade policy Increase in export

• Reducing imports to improve the balance of trade.

• The government intervenes by: taxing imported goods, using
quotas, currency devaluation, etc.
• These policies will create 2 types of impacts: Immediate effects
and long-term effects
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4.3. Trade policy Decrease in import

• Immediate effect
Reduce the autonomous import 𝑀𝑜
- Output: ∆𝑌 = 𝑘. ∆𝐴𝐷0 = 𝑘. −∆𝑀 > 0
- Trade balance: ∆𝑀∗ = 𝑀𝑚. ∆𝑌 = 𝑀𝑚. 𝑘. (−∆𝑀)
If 𝑀𝑚. 𝑘 < 1 trade balance will be enhanced
• Long-term effect
Reduce the marginal import 𝑀𝑚

𝐶𝑜 + 𝐼𝑜 + 𝐺𝑜 + 𝑋𝑜 − 𝑀𝑜 − 𝐶𝑚. 𝑇𝑜
𝑌=
1 − 𝐶𝑚 1 − 𝑇𝑚 − 𝐼𝑚 + 𝑀𝑚
- Output: 𝑀𝑚 ↓ => 𝑌𝐸 ↑
- Trade balance: depends on 𝑀𝑚. 𝑘
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Example 3

An open economy has following functions:

𝐶 = 70 + 0.75𝑌𝑑 𝐼 = 100 + 0.2𝑌 𝐺 = 320
𝑋 = 500 𝑀 = 350 + 0.25𝑌
a. Define the equilibrium output when the budget is balanced.
b. In fact, the marginal tax is 0.1, autonomous tax is 200. Determine the
equilibrium output in this case.
c. If exports increase by 20, investment changes by 10, consumption changes
by 50. What is the new equilibrium output?
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1. Suppose an economy has constant prices, interest rates, and exchange rates. The
economy has following functions:

C = 0.8Yd + 1,000 T = 0.25Y + 500 G = 1,500

M = 0.1Y + 1,000 X = 400 I = 500

a. Calculate equilibrium income. Government budget surplus or deficit?

b. Use the multiplier to recalculate equilibrium income when government spending

increases by 100. Any comments on the government budget?

c. To achieve equilibrium income as in b, but not by increasing government spending but by

reducing autonomous taxes, by how much must net tax is reduced.

d. Starting from a situation like a, if the government simultaneously increases public

spending and increases taxes by the same amount of 100, what is the equilibrium income?

e. Of the types of fiscal policy mentioned above, which one do you favor? Why?
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2. Suppose an economy has following information: (Unit: billion USD)

C = 100 + 0.8Yd I = 300 G = 250
X = 300 M = 50 + 0.12Y T = 0.1Y Yp = 2500
a. Calculate the equilibrium output.
b. Comments on the state of the budget and the balance of trade.
c. What would be the actual output if the budget is in equilibrium?
d. If exports increase by 20, is the balance of trade in balance? Explain.
e. In order to Yt = Yp how should the government conduct fiscal policy? Quantitate for
fiscal policy in this case (all 3 cases: change only G, change only T, change both G and T
simultaneously).
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3. An economy has following functions:

C = 170 + 0.75Yd I = 220 + 0.15Y
T = 40 + 0.2Y Yp = 8800
a. Calculate the output at which the budget is balanced? What is the
equilibrium budget?
b. If household consumption increases by 20, investment increases by 30,
the government cuts spending by 10, calculate the new equilibrium
output.
c. To bring the equilibrium output from b to potential output, by how
much should the government increase spending on goods and services?
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4. Consider an open economy with exports of 5 billion VND and marginal

propensity to import 0.14. Autonomous consumption is 10 billion, the marginal
propensity to consume is 0.8. Domestic investment by the private sector is 5
billion VND. The government spends 40 billion dong and levies taxes equal to 20%
of national income.
a. Determine the level of autonomous expenditure of the economy.
b. Build the total expenditure function and display it on the graph.
c. Determine the equilibrium level of output.
Now, suppose the government increases expenditure on goods and services by
20 billion. Let's:
d. Determine the new equilibrium level of output and plot it.
e. Calculate the change in autonomous expenditure, the part of which depends
on income, consumption, imports, and investment.
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5. Figure 4.1 depicts the aggregate expenditure curves of an economy

with and without international trade.
a. Which curve is the aggregate expenditure curve with and without
international trade?
b. Determine the equilibrium level of output in the absence of
international trade.
c. Determine the equilibrium level of output in the presence of
international trade. Then the trade balance deficit or surplus?
d. What level of output ensures a balanced trade balance?
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Figure 4.1 Figure 4.2

AE AE

𝐴𝐸2
B

𝐴𝐸1
D
C
𝐴𝐸0

450 450
G H I Y 𝑌0 𝑌1 𝑌2 Y
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6. Figure 4.2 shows the aggregate expenditure function of an open

economy, where taxes are proportional to income.
a. Explain what causes the aggregate expenditure curve to shift from
AE0 to AE1.
b. Explain what causes the aggregate expenditure curve to shift from
AE1 to AE2.
c. Is the expenditure multiplier corresponding to curve AE2 greater
or smaller than the multiplier corresponding to curve AE1? Why?
d. What macroeconomic policies can be used to increase output
from Y0 to Y1 and from Y1 to Y2?