CHAPTER 4

The government and fiscal policy and equilibrium output

Government in the Economy                                                                           

   - Fiscal policy is the government’s spending and taxing policies.                 

- Monetary policy is the behavior of the Bank of Canada regarding the nation’s money supply.                                                                                               

- Discretionary fiscal policy is the changes in taxes or spending that are the result of deliberate changes in government policy

Disposable Income                                                                                             

  - Net taxes are taxes paid by firms and households to the government minus transfer payments made to households by the government.                          

  - Disposable income or after-tax income (Yd) is total income minus net taxes:>Yd = Y - T                  

Aggregate Expenditures with Government                                                      

    Yd = Y - T 

          Yd = C + S

          Y - T = C + S

          Y = C + S + T

          AE = C + I + G

 

Government Budget Surplus/Deficit                                                                           

- Budget deficit is the difference between what a government spends and what it collects in net taxes in a given period: G – T

-Budget surplus is net taxes minus government purchases: T - G. Also called the budget balance.

 

Consumption with Government                                                                       

  Instead of C = a + bY

          we have C = a + bYd

                        or

              C = a + b (Y - T)

 

Finding Equilibrium Output                                                                             

Since equilibrium occurs where Y = AE and

                             AE = C + I + G

          the equilibrium condition is Y = C + I + G.

                   From the example:

                   C = 100 + 0.75Yd or C = 100 + 0.75(Y - T)

          We add to this the assumptions that government spending is 100 billion, net taxes are 100 billion and planned investment is 100 billion.

 

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

(10)

OUTPUT
(INCOME)      Y

 

NET
TAXES T

DISPOSABLE
INCOME          Yd = Y - T

CONSUMPTION
SPENDING
(C = 100 + .75 Yd)

 

SAVING
S
(YdC)

 

PLANNED
INVESTMENT
SPENDING
I

 

GOVERNMENT
PURCHASES
G

PLANNED
AGGREGATE
EXPENDITURE
 C + I + G

 

UNPLANNED
INVENTORY
CHANGE
Y - (C + I + G)

 

ADJUSTMENT
TO
DISEQUILI-

BRIUM

 

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 ↓

 

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.

        - If the government wishes to increase output by a certain level, for instance 200 billion, to reduce unemployment, it would not need to increase government spending by the same amount because of the multiplier.              

       - Government spending is a component of autonomous expenditure, similar to investment. Therefore the government spending multiplier is equal to 1 / MPS.

      - In C = 100 + 0.75Yd the MPS is equal to 0.25 (1 - MPC) and the multiplier equal to 4.

       - To increase equilibrium output by 200 billion the government would only have to increase spending by 200/4 = 50 billion.

 

The Tax Multiplier                                                                                            

 - The tax multiplier is the ratio of change in the equilibrium level of output to a change in taxes.

        - The multiplier for a change in taxes is not the same as the multiplier for a change in government spending.                                                   

 - Taxes do not directly impact spending like government spending does, rather they influence disposable income, which influences the household’s consumption (which is part of total spending).

                 AY = (Initial increase in aggregate expenditure) x 1/MPS

Since the initial change in AE caused by AT is equivalent to - AT x MPC

     AY = (- AT x MPC) x (1/MPS) = - AT x (MPC/MPS)

so the Tax Multiplier (AY/AT) = - (MPC/MPS)

 

Balanced-Budget Multiplier                                                                               

- The balanced -budget multiplier is the ratio of change in 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 change the

surplus or deficit.

-The balanced -budget multiplier is equal to 1: the change in Y resulting from the change in G and the equal change in T is exactly the same size as the initial change in G or T itself.


Adding the International Sector                                                                        

- The models presented so far have been in a closed economy without trade.

       -In an open economy net exports (exports - imports) are added to output.

                                                Y = C + I + G + (EX - IM)

          -If (EX - IM) is equal to zero then the expression can be omitted.

 

The Leakages/Injections Approach to Equilibrium

                             For equilibrium Y = AE

          Y = C + S + T and AE = C + I + G + EX - IM

                          C + S + T = C + I + G + EX - IM

                               S + T = I + G + EX - IM

                               S + T + IM = I + G + EX

                          LEAKAGES = INJECTIONS

 

Federal Budget

-The federal budget is the budget of the federal government, listing in great detail all the things the government plans to spend money on and all the sources of government revenues for the coming year.

 

 

 

 

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