Lecture 4

Fiscal Policy
Fiscal Policy in Simple Keynesian System
UGBS 204: Macroeconomics for Business
UGBS 204: Lecture four

Fiscal Policy
Outline
1 Fiscal Policy
Meaning of Fiscal Policy
Fiscal Policy As StabilizationTool
Other Issues Related to Fiscal Policy

Fiscal Policy Fiscal Policy As StabilizationTool
Outline
1 Fiscal Policy

What is Fiscal Policy?
Fiscal policy refers to changes in the level of government

spending and/or taxes meant to inuence the level of
economic activity


economic activity
Reading of the budget statement is announcement of gov't

scal policy


economic activity

scal policy
Fiscal policy may be expansionary or contractionary


economic activity

scal policy
Expansionary policy: also scal loosening refers to increases in

govt spending or reduction taxes

Types of Fiscal Policy

Expansionary policy: (scal loosening) refers to increases in

govt spending and/or reduction taxes

Expansionary policy: (scal loosening) refers to increases in

govt spending and/or reduction taxes
Contrationary policy: (scal tightening) refers to increases in

govt taxes and/or reduction in govt spending
scal austerity

Fiscal Policy in the Simple Keynesian System
Recall from last week: basic relationships in this economy are:

C = a + bY d
I = I0
G = Go , T = T0


C = a + bY d
I = I0
G = Go , T = T0
The equilibrium condition requires that Y=AD


C = a + bY d
I = I0
G = Go , T = T0
The equilibrium condition requires that Y=AD
That is:
Y = AD = a + b(Y − T ) + I0 + G0
Y − bY = a + I0 => Y (1 − b) = a − bT0 + I0 + G0
Y e = a−bT10−b
+I0 +G0

Autonomous Spending Multipliers
1
Recall from last week: 1−b is called the autonomous
expenditure multiplier

1
It is a multiple by which a change in any component of

autonomous expenditures increases equilibrium output

1
It is a multiple by which a change in any component of

autonomous expenditures increases equilibrium output
In this framework, the components of autonomous spending

are
a, I0 , G0

Autonomous Tax Multipliers
a−bT0 +I0 +G0

Ye = 1−b

a−bT0 +I0 +G0

Ye = 1−b
From the previous example, what is the eect on an increase

in taxes (T0 ) on equilibrium income Y e

a−bT0 +I0 +G0

Ye = 1−b

If we dierentiate Y e with respect to T0 we have:

∂Y e −b
∂ T0 = 1−b

a−bT0 +I0 +G0

Ye = 1−b

If we dierentiate Y e with respect to T0 we have:

∂Y e −b
∂ T0 = 1−b
This is the autonomous tax multiplier that shows the eect of

changes in autonomous taxes on equilibrium
the negative shows that an increase in tax will reduce
equilibrium income

Balanced-budget Multiplier (1)
What will be multiplier be if government increased its

spendingby raising an equal amount in autonomous tax?


The balanced-budget multiplier shows the eect on income of

an increase in government spending and autonomous taxes by
equal amounts


The balanced-budget multiplier shows the eect on income of

an increase in government spending and autonomous taxes by
equal amounts
The balanced budget multiplier is 1, this means that

equilibrium income will increase by the same amount of the
increase in government spending and taxes

Balanced-budget Multiplier(2)
To see this, note that if G increases by 4G , the overall eect

1
on Y will be 4G ∗ 1−b


1
If T increases by 4T the eect on Y will be −4T ∗ 1−bb
Note that since taxes and spending increase by the same

amount, 4G = 4T ,


1
If T increases by 4T the eect on Y will be −4T ∗ 1−bb
Note that since taxes and spending increase by the same

amount, 4G = 4T ,
Add the two eects up gives:

1
4G ∗ 1−b b
− 4G ∗ 1−b = 4G ( 11−b
−b
) = 4G

Example (1)
Consider the following:

C = 100 + 0.8Y d
I = 200
G = 80, T = 70

Example (1)
Consider the following:

C = 100 + 0.8Y d
I = 200
G = 80, T = 70
In this example, the marginal propensity to consume is 0.8

80% of any additional income goes to consumption

Example (2)
In this example, the autonomous spending multiplier is:

1 1
1−b = =5
1−0.8
If any component of autonomous spending increase by 1 unit,
output will increase by 5 units

Example (2)
In this example, the autonomous spending multiplier is:

1 1
1−b = =5
1−0.8
If any component of autonomous spending increase by 1 unit,
output will increase by 5 units
The autonomous tax multiplier is

−0.8
−b
1−b = = −4
1−0.8
An increase in autonomous taxes by 1 unit will decrease
equilibrium income by 4 units

Example (3)
We can now solve for the equilibrium

Example (3)
We can now solve for the equilibrium
In equilibrium Y=AD
Y = 100 + 0.8(Y − 70) + 200 + 80
Y = 324 + 0.8Y
0.2Y = 324
Y=1620

Outline
1 Fiscal Policy

Actual GDP, Potential GDP and Output Gap
Actual GDP (Y ∗ ) refers to what the economy does produce,

whilst Potential GDP (Yp ) refers to what the economy could
produce if all the resources in the economy are fully utilized


The dierence between what the economy could have

produced and what actually is produced is referred to as the
Output (GDP) Gap


The dierence between what the economy could have

produced and what actually is produced is referred to as the
Output (GDP) Gap
Output gap = Yp − Y ∗
If output gap is positive ie Yp > Y ∗ we have recessionary gap
If output gap is negative ie Yp < Y ∗ we have ination gap
If output gap is zero ie Yp = Y ∗ we have full employment

Recessionary Gap

Inationary Gap

Fiscal Policy as Stabilization Tool
A major goal of scal policy is to stabilize actual output close

to the potential output


If actual output is greater than potential output (inationary

gap), contractionary scal policy can be used reduce output to
the potential output


If actual output is greater than potential output (inationary

gap), contractionary scal policy can be used reduce output to
the potential output
If actual output is less than potential output (recessionary

gap), expansionary scal policy can be used to increase output
to the full employment output.

Consider our previous example:

C = 100 + 0.8Y d
I = 200
G = 80, T = 70


C = 100 + 0.8Y d
I = 200
G = 80, T = 70
We saw that the equilibrium income or actual output 1620


C = 100 + 0.8Y d
I = 200
G = 80, T = 70
We saw that the equilibrium income or actual output 1620
Suppose the potential output is 2000

in this example we have a recessionary gap

The government can use an expansionary scal policy to

remove this gap


remove this gap
Since the output gap is 380=2000-1620 and the autonomous

spending multiplier is 5 government does not have to increase
spending by 380
Government can increase spending by only 76
380
4G = 5 = 76


remove this gap
Since the output gap is 380=2000-1620 and the autonomous

spending multiplier is 5 government does not have to increase
spending by 380
Government can increase spending by only 76
380
4G = 5 = 76
If government alternatively chose to reduce taxes, by how

much should taxes be reduced??

Outline
1 Fiscal Policy

Autonomatic Stabilizes
Autonomatic stabilizers refer to in-built scal mechanisms

within an economy that dampens eects of uctuations in
aggregate demand on actual output


They ensure that during recessions, when loss of jobs lead to

loss of incomes, consumption expenditures do not fall so much
to deepen the recession



Examples include unemployment insurance/compensation



Examples include unemployment insurance/compensation
Autonomatic stabilizers are more prominent in developed

countries than in developing countries

Crowding-out Eect
Expansionary scal policy stimulates aggregate demand for

goods and services but also raises interest rates
Governments borrows when it runs expansionary scal policy
The additional borrowing raises interest rate

Crowding-out Eect

Higher interest rate increases the cost of investment, reducing

investment
Higher interest rates may also reduce private consumption

Crowding-out Eect

Higher interest rate increases the cost of investment, reducing

investment
Higher interest rates may also reduce private consumption
Crowding-out refers oset in aggregate demand that results

when expansionary scal policy raises the interest rate and
thereby reduce investment spending

Lecture 4

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Fiscal Policy

Fiscal Policy in Simple Keynesian System

UGBS 204: Macroeconomics for Business

UGBS 204: Lecture four

UGBS 204: Lecture four

UGBS 204: Lecture four

What is Fiscal Policy?

Fiscal policy refers to changes in the level of government

UGBS 204: Lecture four

What is Fiscal Policy?

Fiscal policy refers to changes in the level of government

Reading of the budget statement is announcement of gov't

UGBS 204: Lecture four

What is Fiscal Policy?

Fiscal policy refers to changes in the level of government

Reading of the budget statement is announcement of gov't

Fiscal policy may be expansionary or contractionary

UGBS 204: Lecture four

What is Fiscal Policy?

Fiscal policy refers to changes in the level of government

Reading of the budget statement is announcement of gov't

Fiscal policy may be expansionary or contractionary

Expansionary policy: also scal loosening refers to increases in

UGBS 204: Lecture four

Types of Fiscal Policy

Fiscal policy may be expansionary or contractionary

UGBS 204: Lecture four

Types of Fiscal Policy

Fiscal policy may be expansionary or contractionary

Expansionary policy: (scal loosening) refers to increases in

UGBS 204: Lecture four

Types of Fiscal Policy

Fiscal policy may be expansionary or contractionary

Expansionary policy: (scal loosening) refers to increases in

Contrationary policy: (scal tightening) refers to increases in

UGBS 204: Lecture four

Fiscal Policy in the Simple Keynesian System

Recall from last week: basic relationships in this economy are:

UGBS 204: Lecture four

Fiscal Policy in the Simple Keynesian System

Recall from last week: basic relationships in this economy are:

The equilibrium condition requires that Y=AD

UGBS 204: Lecture four

Fiscal Policy in the Simple Keynesian System

Recall from last week: basic relationships in this economy are:

The equilibrium condition requires that Y=AD

UGBS 204: Lecture four

Autonomous Spending Multipliers

UGBS 204: Lecture four

Autonomous Spending Multipliers

It is a multiple by which a change in any component of

UGBS 204: Lecture four

Autonomous Spending Multipliers

It is a multiple by which a change in any component of

In this framework, the components of autonomous spending

UGBS 204: Lecture four

Autonomous Tax Multipliers

a−bT0 +I0 +G0

UGBS 204: Lecture four

Autonomous Tax Multipliers

a−bT0 +I0 +G0

From the previous example, what is the eect on an increase

Expansionary policy: also scal loosening refers to increases in

Expansionary policy: (scal loosening) refers to increases in

Expansionary policy: (scal loosening) refers to increases in

Contrationary policy: (scal tightening) refers to increases in

From the previous example, what is the eect on an increase

From the previous example, what is the eect on an increase

If we dierentiate Y e with respect to T0 we have:

From the previous example, what is the eect on an increase

If we dierentiate Y e with respect to T0 we have:

This is the autonomous tax multiplier that shows the eect of

The balanced-budget multiplier shows the eect on income of

The balanced-budget multiplier shows the eect on income of

To see this, note that if G increases by 4G , the overall eect

To see this, note that if G increases by 4G , the overall eect

If T increases by 4T the eect on Y will be −4T ∗ 1−bb

To see this, note that if G increases by 4G , the overall eect

If T increases by 4T the eect on Y will be −4T ∗ 1−bb

Add the two eects up gives:

The dierence between what the economy could have

The dierence between what the economy could have

A major goal of scal policy is to stabilize actual output close

A major goal of scal policy is to stabilize actual output close

If actual output is greater than potential output (inationary