Fiscal Policy

Role of Government in the

Economy
 Government can affect the macro economy
in two ways:
 Fiscal policy is the manipulation of government
spending and taxation.
 Monetary policy refers to the behavior of the
Federal Reserve regarding the nation’s money
supply.
 Introduction
 Before the 1930s, fiscal policy was not explicitly used to
influence the macroeconomy
 The classical approach implied that natural market forces, by way
of flexible prices, wages, and interest rates, would move the
economy toward its potential GDP. Thus there appeared to be no
need for government intervention in the economy
 Before the onset of the Great Depression, most economists
believed that active fiscal policy would do more harm than
good
The Great Depression and World War II
 Three developments bolstered the use of fiscal policy

 The publication of Keynes’ General Theory

 War-time demand on production helped pull the U.S. out of

the Great Depression
 The Full Employment Act of 1946, which gave the federal
government responsibility for promoting full employment and
price stability
 What is Fiscal Policy?
 Fiscal policy is the deliberate manipulation of government
purchases, transfer payments, taxes, and borrowing in
order to influence macroeconomic variables such as
employment, the price level, and the level of GDP
 Discretionary fiscal policy refers to deliberate changes
in taxes or spending.
 The government can not control certain aspects of the
economy related to fiscal policy. For example:
 The government can control tax rates but not tax revenue.
Tax revenue depends on household income and the size of
corporate profits.
 Government spending depends on government decisions and
the state of the economy.
 The Government Budget
 A plan for government expenditures and
revenues for a specified period, usually a year
 The Budget Deficit

 A government’s budget deficit is the difference

between what it spends (G) and what it collects in
taxes (T) in a given period:

B u d g e t d e fic it  G  T
 If G exceeds T, the government must borrow from
the public to finance the deficit. It does so by
selling Treasury bonds and bills. In this case, a
part of household saving (S) goes to the
government.
 Budget Deficits and Surpluses
 When budgeted expenditures exceed projected tax revenues,
the budget is projected to be in deficit and When projected tax
revenues exceed budgeted expenditures, the budget is
projected to be in surplus
 Indicators of Fiscal Crisis - The main indicators of fiscal crisis
are various deficits such as :-
 Revenue Deficit (RD) : It is the difference between revenue
receipts (income) and revenue expenditure.
 Budgetary Deficit (BD) : It is the difference between total
expenditure and total receipts. Here, both revenue and capital
expenditure and receipts are considered.
 Fiscal Deficit (FD) : It is the excess of total expenditure over
revenue receipts and grants. In other words, fiscal deficit is the
budget deficit plus government borrowings and other liabilities.
 Primary Deficit (PD) : It is the fiscal deficit minus interest
payments.
Rationale for Budget Deficits
 Large capital projects (highways, etc.)
 The benefits from these project will benefit more
than current taxpayers, so deficit financing is
appropriate
 Major Wars
 Keynesian economics points to the use of deficits
to stimulate the economy during periods of
economic slowdown
 Automatic stabilizers tend to increase deficits,
since during times of recession, taxes are reduced
while unemployment insurance and welfare
payments are increased
Causes of Budget Deficit
Crowding Out and Crowding In
 Crowding out--When the government
undertakes expansionary fiscal policy, interest
rates increase due to competition for borrowed
funds and increased transactions demand for
money
 As a result, private investment is “crowded out” due to
increases in public investment
 Crowding in—If expansionary fiscal policy raises
the general level of prosperity in the economy,
private investors may expect greater
investment-related profits, causing private
investment to increase
Net Taxes (T), and Disposable Income
(Yd)

 Net taxes are taxes paid by firms

and households to the government
minus transfer payments made to
households by the government.
 Disposable, or after-tax, income
(Yd ) equals total income minus
taxes.

Yd  Y  T
 Adding Net Taxes (T) and Government
Purchases (G) to the Circular Flow of Income

 When government enters the picture, the

aggregate income identity gets cut into
three pieces:
Yd  Y  T
Yd  C  S
Y  T  C  S
Y  C  S  T
• And aggregate expenditure (AE) equals:

AE  C  I  G
Adding Taxes to the
Consumption Function
C  a  bYd
Yd  Y  T

C  a  b(Y  T )
 The aggregate consumption
function is now a function of
disposable, or after-tax, income.
The Leakages/Injections Approach
 Taxes (T) are a leakage from the flow of
income. Saving (S) is also a leakage.
 In equilibrium, aggregate output (income)
(Y) equals planned aggregate expenditure
(AE), and leakages (S + T) must equal
planned injections (I + G). Algebraically,

AE  C  I  G
Y  C  S  T
C  S  T  C  I  G
S  T  I  G
 Equilibrium Output: Y = C + I + G
C  1 0 0  .7 5 Y d C  1 0 0  .7 5 ( Y  T )
Finding Equilibrium for I = 100, G = 100, and T = 100
(All Figures in Billions of Dollars)
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
UNPLANNED
PLANNED PLANNED INVENTORY
OUTPUT NET DISPOSABLE CONSUMPTION SAVING INVESTMENT GOVERNMENT AGGREGATE CHANGE ADJUSTMENT
(INCOME) TAXES INCOME SPENDING S SPENDING PURCHASES EXPENDITURE Y  (C + I + TO
Y T Yd Y  T (C = 100 + .75 Yd) (Yd – C) I G C+I+G G) DISEQUILIBRIUM

300 100 200 250  50 100 100 450  150 Output

500 100 400 400 0 100 100 600  100 Output
700 100 600 550 50 100 100 750  50 Output
900 100 800 700 100 100 100 900 0 Equilibrium

1,100 100 1,000 850 150 100 100 1,050 + 50 Output

1,300 100 1,200 1,000 200 100 100 1,200 + 100 Output
1,500 100 1,400 1,150 250 100 100 1,350 + 150 Output
Finding Equilibrium
Output/Income Graphically
The Government Spending
Multiplier
 The government spending
multiplier is the ratio of the
change in the equilibrium level of
output to a change in government
spending.
1
G o v e r n m e n t s p e n d in g m u ltip lie r 
M PS
 The Government Spending
Multiplier
Finding Equilibrium After a $50 Billion Government Spending Increase
(All Figures in Billions of Dollars; G Has Increased From 100 in Table 25.1 to 150 Here)

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
PLANNED PLANNED UNPLANNED
OUTPUT NET DISPOSABLE CONSUMPTION SAVING INVESTMENT GOVERNMENT AGGREGATE INVENTORY ADJUSTMENT
(INCOME) TAXES INCOME SPENDING S SPENDING PURCHASES EXPENDITURE CHANGE TO
Y T Yd Y  T (C = 100 + .75 Yd) (Yd – C) I G C+I+G Y  (C + I + G) DISEQUILIBRIUM

300 100 200 250  50 100 150 500  200 Output

500 100 400 400 0 100 150 650  150 Output

700 100 600 550 50 100 150 800  100 Output

900 100 800 700 100 100 150 950  50 Output

1,100 100 1,000 850 150 100 150 1,100 0 Equilibrium

1,300 100 1,200 1,000 200 100 150 1,250 + 50 Output

 The Effect on GDP of an Increase
in Government Spending

$ C+I+G’+(X-M)
45 o

C+I+G+(X-M)

G Simple
Simplegovernment
governmentexpenditures
expendituresmultiplier
multiplier==

GDP/G
GDP/G==1/(1-MPC)
1/(1-MPC)

GDP Real GDP

The Government Spending
Multiplier
The Tax Multiplier
 A tax cut increases disposable
income, and leads to added
consumption spending. Income will
increase by a multiple of the
decrease in taxes.
 A tax cut has no direct impact on
spending. The multiplier for a
change in taxes is smaller than the
multiplier for a change in
government spending.
 The Tax Multiplier
 1 
 Y  (in itia l in c re a s e in a g g re g a te e x p e n d itu re )   
 M PS 

 1   M PC 
Y  (T  M PC )    T   
 M PS   M PS 

 M PC 
T a x m u ltip lie r    
 M PS 
The Effect on GDP of a Decrease
in Taxes

$ C’+I+G+(X-M)
45 o

C+I+G+(X-M)

Simple
Simpletax
taxmultiplier
multiplier==
GDP/T
GDP/T==-MPC/(1-MPC)
-MPC/(1-MPC)

GDP Real GDP

The Balanced-Budget Multiplier
 The balanced-budget multiplier
is the ratio of change in the
equilibrium level of output to a
change in government spending
where the change in government
spending is balanced by a change in
taxes so as not to create any deficit.
 The Balanced Budget Multiplier
 A factor that show that identical changes
in government purchases and net taxes
change real GDP demanded by that same
amount
 1   - MPC 
Change in Y  Change in G    + Change in T   
 1- MPC   1- MPC 
Change in G  Change in T 
 1 MPC 
Change in Y  Change in G     = Change in G
 1- MPC 1- MPC 
 The Balanced-Budget Multiplier
Finding Equilibrium After a $200 Billion Balanced Budget Increase in G and T
(All Figures in Billions of Dollars; G and T Have Increased From 100 in Table 25.1 to 300 Here)

(1) (2) (3) (4) (5) (6) (7) (8) (9)

PLANNED PLANNED UNPLANNED
OUTPUT NET DISPOSABLE CONSUMPTION INVESTMENT GOVERNMENT AGGREGATE INVENTORY ADJUSTMENT
(INCOME) TAXES INCOME SPENDING SPENDING PURCHASES EXPENDITURE CHANGE TO
Y T Yd Y  T (C = 100 + .75 Yd) I G C+I+G Y  (C + I + G) DISEQUILIBRIUM

500 300 200 250 100 300 650  150 Output

700 300 400 400 100 300 800  100 Output

900 300 600 550 100 300 950  50 Output

1,100 300 800 700 100 300 1,100 0 Equilibrium

1,300 300 1,000 850 100 300 1,250 + 50 Output

1,500 300 1,200 1,000 100 300 1,400 + 100 Output

 Fiscal Policy Multipliers
Summary of Fiscal Policy Multipliers
FINAL IMPACT ON
POLICY STIMULUS MULTIPLIER EQUILIBRIUM Y
Government- Increase or decrease in the
spending level of government 1 1
multiplier purchases: G 
M PS M PS
Tax multiplier Increase or decrease in the
level of net taxes:
 M PC  M PC
T 
M PS M PS
Balanced- Simultaneous balanced-budget
budget increase or decrease in the
multiplier level of government purchases
1
and net taxes:
G
 The Economy’s Influence
on the Government Budget
 Fiscal drag is the negative effect on the economy that
occurs when average tax rates increase because taxpayers
have moved into higher income brackets during an
expansion.
 The time required to approve and implement fiscal
legislation may hamper its effectiveness and weaken fiscal
policy as a tool of economic stabilization
 In the case of an oncoming recession, it may take time to
 Recognize the coming recession

 Implement the policy

 Let the policy have its impact