BUS1614 Macroeconomics

Demand-
Management :
Fiscal policy
Fiscal policy
Changes in Tax, Government Spending (& Transfer
payments in many countries) that are intended to achieve
macroeconomic policy objectives.

Macroeconomic objectives: such as full employment,

sustained economic growth, and price level stability.
 UK public-sector deficit measures, 1965–2010
16
Public-sector net borrowing
14 Public-sector net cash requirement

12

10

8
% of GDP

-2

-4
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Source: based on Time series data (National Statistics)

 Government / Public-Sector Budget
The budget is the annual statement of the federal
government’s spending and government revenues.

The federal budget has two purposes:

1. To finance the expenditure plans of the federal government

2. To achieve macroeconomic objectives

 Budget Deficit / Surplus

The budget captures information on the federal

government’s policy on fiscal measures for the economy
Budget :

= Revenue – Expenditure
= (t Y + T) – (G + TR)

If revenue > expenditure Budget surplus

If revenue < expenditure Budget deficit
In which case the government has to
borrow to finance its budget, usually by
selling government bonds
 The federal
The Federal Government Budget: 2002 to 2009 government
has been
Revenue Comprises
Public 2 Government
running
from tax consumption
parts Investment
budget
collections
RM juta deficits since
Current budget Development expenditure 1998
Gross Net Overall
Surplus / Less: Loan
Revenue Expenditure1 development development surplus /
deficit(-) recoveries
expenditure expenditure deficit(-)

2002 83,515 68,699 14,816 35,977 908 35,069 -20,253

2003 92,608 75,224 17,384 39,353 1,041 38,312 -20,928

2004 99,397 91,298 8,099 28,864 1,346 27,518 -19,419

2005 106,304 97,744 8,560 30,534 3,250 27,284 -18,724

2006 123,546 107,694 15,852 35,807 846 34,961 -19,109

2007 139,885 123,084 16,801 40,564 3,105 37,460 -20,659

2008 159,793 153,499 6,295 42,847 959 41,889 -35,594

2009 158,639 157,067 1,572 49,515 519 48,997 -47,424

Source: BNM
And the deficit
got bigger
 Government Revenue
RM juta
RM juta Induced autonomous
Hasil cukai taxes Hasil
taxes (tY) Hasil cukai
Tax revenue
Hasil bukan
bukan cukai
cukai
Hasil bukan cukai
Tax revenue
Cukai tidak
Cukai
Cukai langsung Cukai tidak
tidak
Cukai langsung langsung
langsung Non-tax revenue111
langsung Non-tax
Non-tax revenue
revenue Extractfrom
from
Tempoh Jumlah Direct taxes Indirect taxes Extract
Tempoh Jumlah
Tempoh Jumlah Direct taxes
Direct taxes Indirect
Indirect taxes
taxes
Extract
(1)
(1) & from
(3)
(1)&& (3)
(3)
Petronas
Petronas Petronas
Petronas
Petronas Petronas
Jumlah
Jumlah Jumlah
Jumlah Jumlah
Jumlah Income
Income Income
Income
Jumlah Jumlah Jumlah Income Income
kecil
kecil kecil
kecil kecil
kecil tax &
tax tax &
kecil kecil kecil tax && tax
tax &&
profits
profits profits
profits
profits profits
(1)
(1) (2)
(2) (3)
(3)
Period
Period Total
Total (1) (2) (3) $'000
$'000 %%
Period Total Sub-total
Sub-total Sub-total
Sub-total Sub-total
Sub-total $'000 %
Sub-total Sub-total Sub-total
2002
2002
2002
83,515
83,515
83,515
44,351
44,351
44,351 53.1%
53.1% Petronas’
53.1% 22,509
22,509
22,509
27.0%
27.0%
27.0%
15,759
15,759
15,759
18.9%
18.9%
18.9%
15,989
15,989
15,989
19.15%
19.15%
19.15%
2003
2003 92,608
92,608 43,016
43,016 46.4% contribution
46.4% 21,875
21,875 23.6%
in
23.6% 23,131
23,131 25.0%
25.0% 23,667
23,667 25.56%
25.56%
2003 92,608 43,016 46.4% 21,875 23.6% 23,131 25.0% 23,667 25.56%
2004
2004 99,397
99,397 48,703
48,703 49.0% 23,347
49.0%share
23,347 23.5%
23.5% 26,511
26,511 26.7%
26.7% 29,257
29,257 29.43%
29.43%
2004 99,397
106,304
48,703 49.0% its share
23,347of profits
of
23.5% 26,511 26.7% 29,257 29.43%
106,304
106,304
2005
2005 53,543
53,543 50.4%profits
50.4% to budget
27,051
27,051& taxes
25.4% 25,052
25.4% 25,052 23.6% 29,415
23.6% 27.67%
2005 53,543 50.4% 27,051 25.4% 25,052 23.6% 29,415
29,415 27.67%
27.67%
123,546
123,546 to budget
123,546
2006
2006 61,572
61,572 49.8% 25,058
49.8% 25,058 20.3% 36,005
20.3% 36,005 29.1% 45,468
29.1% 36.80%
2006 61,572 49.8% 25,058 20.3% 36,005 29.1% 45,468
45,468 36.80%
36.80%
139,885
139,885
139,885
2007
2007 69,396
69,396 49.6% 25,772
49.6% 25,772 18.4% 43,950
18.4% 43,950 31.4% 52,861
31.4% 37.79%
2007 69,396 49.6% 25,772 18.4% 43,950 31.4% 52,861
52,861 37.79%
37.79%
159,793
159,793
159,793
2008
2008 82,138
82,138 51.4% 30,760
51.4% 30,760 19.2% 45,911
19.2% 45,911 28.7% 56,462
28.7% 35.33%
2008 82,138 51.4% 30,760 19.2% 45,911 28.7% 56,462
56,462 35.33%
35.33%
158,639
158,639
158,639
2009
2009 78,375
78,375 49.4% 28,129
49.4% 28,129 17.7% 50,789
17.7% 50,789 32.0% 64,625
32.0% 40.74%
2009
Source: BNM
78,375 49.4% 28,129 17.7% 50,789 32.0% 64,625
64,625 40.74%
40.74%
Petronas (2009): Income tax - RM27.231bil Profits - RM37.394 bil
The Federal Government Budget: 2002 to 2010

Outlay

Revenue

Large budget
deficits in
2008-09 Smaller
deficit in
2010

Overall Surplus/Deficit

2010
-43,275
 Discretionary fiscal policy & the
Business Cycle
In general, the status of the budget tend to reflect the
business cycle i.e.
If a recession: Budget deficits get bigger (or surplus
smaller) – G, T, TR 

If an inflation gap: Budget deficits get smaller (or

surplus increases) – G, T, TR 
However, the budget also reflects how well the government is managing its
finances i.e. an efficiently run civil service with prudent demand management
policies should see larger budget surpluses or smaller deficits

An inefficiently managed government may result in large deficits & large public
debt
Stabilizing the Business Cycle

Fiscal policy actions that seek to stabilize the business

cycle work by changing aggregate demand.

■ Discretionary or

■ Automatic (non-discretionary)

Discretionary fiscal policy is a policy action that is

initiated by the federal government

Automatic (non-discretionary) fiscal policy is a change

in fiscal policy triggered by the state of the economy.
 Discretionary Fiscal Policy: Recession:
Unemployment (Recession) Gap
When there’s recession, the Govt uses
Price expansionary policies (ie G/ T) to AD
LRAS
Level
SRAS0 AD curve shifts right to AD1
Shortage of g & s (-) at P = 100)
110 c
a bAD > AS (-) P  explain wealth & sub
100   effects, & effect on SAS
AD1
The shortage is resolved as
AD0 GDP rises & economy
Y1 Yf Real GDP ($) moves to full employment at
point c
 Discretionary Fiscal Policy: The Inflation Gap
Inflation gap Y1 – Yf - concern over inflation &
Price resource shortages at Y1
Level LRAS
If government can wait, money wage in the
SRAS0 long run can increase, & force the economy
back to full employment (see Lecture 3)
b If government cannot wait, they can intervene
110  a and use contractionary policy i.e. G and/or T
100 c AD curve shifts left
AD0
AD1 AD < AS (+) at P = 110
Yf Y1 Real GDP ($) P: explain wealth & sub
effects, & effect on SAS
The surplus of goods & services is resolved as GDP falls &
the economy moves back to full employment at point c
 Contractionary Fiscal Policy and the
Federal Government Debt
Budget deficits may get too big and the government find itself unable to
repay or finance the deficit with more borrowings
Then it may be forced to reduce spending or raise taxes i.e. contractionary
policy to reduce the deficit Price
Level LAS
SAS0

Possible that the Most recent

economy may suffer b
just so that the
110  a example:
Greece
government is able c
100
to control or rein AD0
back its spending. AD1
Y1 Yf
 Contractionary Fiscal Policy and the Federal Debt
In April 2015, the government introduced the GST – its purpose to improve the
efficiency of the tax collection system so that it can (i) collect more revenue, reduce the
public debt and (ii) have the resources to redistribute its spending more efficiently
GST  - autonomous tax, T – Yd  – C 
Price Level LAS AD   AD curve shifts left to AD01
SAS0 AS > AD (+ surplus of G&S) at P1
b The surplus forces P to P2 – reaction from:-
P1  aa a) Qty of Agg supply  - given money wage
b
P2 c fixed in short run - firms  output as profits
 with price 
AD0 b)  Qty of Agg Dd – explain wealth effect,
intertemporal & international sub effects
AD1
Y1 Yf Real GDP (RM billion)
The surplus is eventually resolved as Y
• Recession gap from Yf to Y1
• unemployment & economy moves to new equilibrium pt c
 Discretionary Fiscal Policy: Recession
Unemployment benefit ie TR/ Income tax (t) - Yd - C

Note: an increase in government spending is G

AD curve shifts right to AD1
Price LRAS
Level Disequilibrium - AD > AS at P=100
SRAS0
P to 110 - reaction from:
a) Qty of Agg supply  - given money wage fixed in
110 c
short run - firms  output as profits with price
b
100
a
  b) Qty of Agg Dd– explain wealth effect,
intertemporal & international sub effects
AD1
AD0 The shortage of G&S is eventually
resolved as Y to Yf
Y1 Yf Real GDP
($billions) Economy moves to new equilibrium
at point b (note: full employment )
 Non Discretionary Fiscal Policy

Automatic Stabilisers
tax system, welfare benefits i.e. transfer payments

components of fiscal policy already in the economic system

that automatically  fluctuations in AD that may arise from
fluctuations in aggregate expenditure
But the policy is only non-discretionary if the system of
stabilisers remains unchanged ie income tax remains at 20%
or GST remains at 6%
If GST is raised to 10% or income tax raised to 30%, then
fiscal policy becomes discretionary

18
 How does an automatic stabiliser work?
Example – requires an income tax and/or transfer payments
system that is already in place

Recession – Unemployment rises, Income falls,

taxable income falls
Also unemployed have access to TR – YD rises, C
rises – helps cushion against recessionary effects

Inflation – shortages rises, income very high – danger

of inflation – higher taxable income removes some of
the excessive demand – brings economy back closer
to Yf
In other words, a stabiliser works automatically to
stabilise business cycle fluctuations to help the economy
stay at a more sustainable level of GDP at Yf
19
 Fiscal Policy
Fiscal policy involves the management of 3 key
components:

G= Government spending on current goods/services

Government spending on development
Adds to AE
Treat as autonomous, G

TR = Govt Transfer Payments

Adds to consumption and thus to AE
Treat as autonomous, TR (or TP)

TA = Tax receipts, T + tY
Minus from AE
2 forms of taxes:
Autonomous, T
Induced, tY 20
The Fiscal Policy Multiplier

The Basic Expression of the Multiplier

Y =  . A

Y
=
A

21
Changes in G: Government Exp Multiplier
Let A = G, ceteris paribus
Y = 1 x G
1 – b(1 – t) + m

Y 1 . = G
 =
G 1 – b(1 – t) + m

The Autonomous
Expenditure Multiplier
Similar multiplier effect if:
Autonomous consumption, a
Autonomous Investment, I
22
Autonomous X & M
 Changes in Equilibrium
Example 1
An economy has the following information in
year 2008:
a = $10b I = $60b G = $90b
X = $10b m = 0.1 TR = $20b
b = 0.9 t = 0.3 T =5

Calculate for 2008:-

(a) Consumption function
(b) determine the aggregate expenditure function
(c) equilibrium output
(d) the expenditure multiplier
(e) the federal budget surplus or deficit
(f) change in real GDP, Y as G increases by $10b in
2009
(g) new equilibrium real GDP, Y2

23
Example 1 (a) C = a + bYd where YD = Y – tY – T + TR
= 10 + 0.9(Y – 0.3Y – 5 + 20)
= 23.5 + 0.63Y
(b) AE = C + I + G + NX
= a + bYD + G + I + X – mY
= 10 + 0.9(Y – 0.3Y – 5 + 20) + 90 + 60 + 10 – 0.1Y
= 183.5 + 0.53Y
(d)  = 1 . = 1
(c) Y = AE 1 - b(1 - t) + m 1 – 0.53
AE = 183.5 + 0.53Y = 2.1277
Y = 183.5 + 0.53Y (e) Budget surplus/deficit:
= 390.426 = (tY + T) – (G + TR)
(f) A = 10 = 0.3(390.43) + 5 – 90 – 20
Y = a x G = 12.129 (surplus)
= 2.1277 x 10 (g) Y2 = Y + Y1
= $21.277b
Given Y0 = 390.426
 Y2 = 21.277 + 390.426
24
= $411.703b
 Changes in Equilibrium
Example 2
The information from Example 2 refers ie in year 2008:
a = $10b I = $60b G = $90b
X = $10b m = 0.1 TR = $20b
b = 0.9 t = 0.3 T =5

Real GDP was $390.426 billion. Suppose the full

employment level of real GDP is $450 billion.

(a) Is the economy facing a recession or inflation?

(b) How much government expenditure should the
government raise or reduce to achieve full employment
(c) How much strain would this place on the federal
budget if the objective is also to achieve at least a
balanced budget?
25
 Example 2
(a) From Example 2, Y = $390.426 billion
Given full employment GDP, Yf = $450b
Y = 450 – 390.426
= $59.57b (recession gap)
(b) From Example 2, a = 2.1277
Y = a x G
59.57 = 2.1277 x G
G = 59.57 / 2.1277
= $27.997b
The government needs to spend $27.9 bil to get the economy back to
full employment
(c) Budget surplus/deficit:
= (tY + T) – (G + TR)
= 0.3(450) + 5 – (90 + 27.997) – 20
= 2.003 (surplus)
The additional spending of $27.997b would not place a strain on the
budget as the additional expenditure is offset by the revenue generated
from direct tax revenue as GDP increases to $450b. However, the
surplus is much smaller on account of additional spending 26
Next Week
Monetary Policy

27