Chapter 10 - GOVERNMENT IN

THE MACROECONOMY

Economics 11 UPLB
Prepared by Tirso B. Paris, Jr.
September 2007
 The Government Budget
Government budget
indicates the public sectors expenditures and sources of
finance
Net budgetary position

revenues > expenditures budget surplus

revenues < expenditures budget deficit

revenues = expenditures balanced budget

 Revenues & Expenditures
(in billion PhP)
Item 2002 2003 2004 2005 2006

Revenues 578 640 707 816 980

Expenditures 789 840 894 963 1,044

Surplus/ -211 -200 -187 -147 -64

Deficit
Ratio of Deficit 5.00 4.32 3.57 2.50 0.99
to GNP
 2007 National Budget and Projected
Revenues
Budget: PhP 1.126 Trillion
RA 9401
social payback to the people for the fiscal
turnaround of their government

Proj. Revenues: PhP 1.118 Trillion

Budget Deficit: PhP 63 Billion

 The 2007 budget will enable us to:
provide free meals to 1.5 million youngsters as
incentive for attending class
recruit 3,000 new policemen

send about 700,000 scholars to schools and colleges

immunize two million children

establish 2,400 outlets of Botika ng Barangay (Village

Pharmacy)
provide medical insurance to 4.4 million poor
persons, among others
- Secretary Rolando Andaya Jr.
How NG spends the 2007 Budget?
Economic services (including agriculture, trade
and natural resource) - 21.8 %
Social services (consisting of health and
education spending) - 28.1%
General public services account for 16.2 %
Defense, 4.8 %
Debt service, 28.3 %
 Top Ten Departments
Education, 128.6 billion
Public works, 71.2-billion
Defense, 54.3 billion
Interior and local government, 51.3 billion
State universities and colleges, 17.3 billion
Agriculture, including the AFMA (Agriculture and Fisheries
Modernization Fund), 17.3 billion
Transportation, 16.9 billion
Health, 11.5 billion
Judiciary, 9.3 billion
Comelec, 9.17 billion
 Government Revenues 2004
ITEM % share

Tax Revenues 85.5

Taxes on net income and profits 39.8

Taxes on property 0.1

Taxes on goods and services 24.0

Taxes on intl trade and transactions 17.5

Other taxes 4.1

Non-Tax Revenues 14.5

TOTAL 100.0
GOVERNMENT AND NATIONAL
INCOME:

THE THREE-SECTOR MODEL

Revisions to the Income Determination
Model
Disposable income (YD) - income that
households are free to spend and save.
YD = Y T
Where Y- income
T- taxes
Aside: for convenience, net transfers to
households = 0
Consumption now depends on disposable
income
 Revision to the Consumption
Function
C c mpc YD
or
C c mpc (Y T )
The above implies that:
when T C
Y = C + S is now replaced by YD = C+S
In a three-sector model,
AE = C + I + G
Thus, in equilibrium:
Y=C+I+G
 Derivation of Equilibrium Income:
Three-Sector economy
Assume:
Lump sum taxes (T T 100)
G is autonomous
(G G 200)
Income and Aggregate Expenditure

Y T YD C I G AE
1,100 100 1,000 950 100 200 1,250
1,300 100 1,200 1,100 100 200 1,400
1,500 100 1,400 1,250 100 200 1,550
1,700 100 1,600 1,400 100 200 1,700
1900 100 1,800 1,550 100 200 1,850
2,100 100 2,000 1,700 100 200 2,000
 Alternative Equilibrium Condition:
3-Sector Model
Equilibrium condition: Y = AE
Equilibrium income is at Y = 1,700
Alternative equilibrium condition:
S+T = I+G
To illustrate, above values suggest that:
I = 100, T = 100, G = 200
In equilibrium,
S = YD C = 1600 1400 = 200.
I + G = 300 = S + T
C c mpc (Y T ), I I , G G

Algebraic Treatment
We know that: C c mpc (Y T ), I I , G G
Y AE C I G leads to Y c mpc (Y T ) I G
Solving for Y, we now have: Y * c I G mpc T )
1
where
1 mpc
In our example:
C = 200 + 0.75 (Y- T)
I = 100
T = 100
G = 200
1
Y * (200 100 200 0.75(100) 1700
1 0.75
 F10.1

Aggregate expenditure (in pesos) AE

AE
E0
1,700

45
Y
0 1,700 2,300
Y*
Income (in pesos)
 Government spending and equilibrium
income
Main point: G AE Y*
How large is the change in income?
1
Y G
*
4 G = 200 Y* = (4).(200) = 800
1 0.75
 F10.2
Aggregate expenditure (in pesos) Govt Spending and Y*
AE

E1 AE1
AE0

E0
G

45

0 Y0 * Y1* Y

Income (in pesos)

 Income taxes and
equilibrium income
Main point: T C AE Y*
How large is the change in income
Y* mpc T mpc 0.75 4 T 100

Y* (0.75) (4) (100) 300

Tax multiplier, = -mpc = -0.75 = -3

1-mpc 0.25
 F10.3

AE

E0 AE0
AE1

E1
-mpc*T

45
0 Y1* Y0* Y
 Fiscal Policy
Fiscal policy - a collective term that refers to the
use of taxation and government spending to
influence the level of income
Expansionary fiscal policy - spending and taxation
aimed at increasing income;
e.g. , G or T
Contractionary fiscal policy - spending and
taxation aimed at decreasing income;
e.g., G or T
 Deflationary Gap
Full employment level of income or output (Yf)
level of income wherein the economys
resources are fully utilized.
Note: Y* not always equal to Yf

Deflationary gap when AE < Y at Yf

Note: With deflationary gap, Y* < Yf
unemployment
To close gap, AE must such that Y* = Yf

Expansionary fiscal policy is required to make

the AE shift up
 F10.2
AE Deflationary Gap

a AE1
AE0
b
c Deflationary
gap

45
Y
0 Y* Yf
 Numerical Example:
Deflationary Gap
If Yf = 2,000 a deflationary gap
exists since Y* < Yf.
In our example:
C = 200 + 0.75 (Y- T) To close gap, use expansionary
I = 100 fiscal policy, e.g., G
T = 100
By how much should G ?
G = 200
Y*= 1,700 GapG = (Yf -Y*)/G
G = 4
= (2,000 1,700)/4
T = -3
= 75
Thus, G should increase by 75 so that Y* = Yf
Check: Y*1 = [(200 + 100 + 275 - ).75(100)] . 4 = 2,000
 Inflationary Gap

Inflationary gap when AE >Y at Yf

There is pressure for an increase in the general
price level (inflation) because it is not possible
to produce beyond Yf.
To close gap, can use contractionary fiscal
policy to shift the AE schedule down
 F10.3
Inflationary Gap
AE

AE0
Inflationary c
gap b AE1

45
Y
0 Yf Y*
 Numerical Example:
Inflationary Gap
If Yf = 1,500 an inflationary gap
In our example: exists since Y* > Yf.
C = 200 + 0.75 (Y- T)
I = 100 To close gap, use contractionary
T = 100 fiscal policy, e.g., T
G = 200 By how much should T ?
Y*= 1,700
G = 4 GapT = (Yf-Y*)/T
T = -3 = (1,500 1,700)/-3
= 66.67
Thus, T should increase by 66.67 so that Y* = Yf
Check: Y*1 = [(200 + 100 + 200) - .75(166.67)] . 4 = 1,500