Topic 4
Fiscal Policy
1
Government in the Economy
•
Government can affect the macro-economy
through two policy channels:
– Fiscal policy
•
Government policy concerning taxes (T) and
expenditure (G).
– Monetary policy.
•
The behavior of central bank concerning the
nation’s money supply (Ms) and interest rate
(i).
2
Government in the Economy
• Two categories:
– Policies
concerning
government
purchases goods and services.
– Policies concerning taxes.
3
• Definition:
Fiscal Policy
– Government policy concerning taxes (T) and
expenditure (G).
• Tools:
– Government expenditure (G) & taxes (T)
• Types:
– Discretionary fiscal policy
– Automatic stabilizers
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Discretionary Fiscal Policy
• Definition:
– Changes in taxes or government spending that are the
result of deliberate changes in government policy.
• Types:
– Expansionary fiscal policy
– Contractionary fiscal policy
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Expansionary Fiscal Policy
• Definition:
– An increase in government spending or a reduction
in net taxes aimed at increasing aggregate output
(income) (Y).
• Function:
– To stimulate the economy.
• Problem:
– Could lead to inflation
– May lead to budget deficit because need debt to
finance the deficit, this will burden the next
generation.
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Unemployment Vs. Fiscal Policy
• Solution:
– Expansionary fiscal policy
➢Increase government expenditure and/or cut
down taxes
➢Increase aggregate expenditure
➢Aggregate output increases
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Unemployment Vs. Fiscal Policy
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Contractionary Fiscal Policy
• Definition:
– A decrease in government spending or an increase
in net taxes aimed at decreasing aggregate output
(income) (Y).
• Function:
– To slow down economy or demand-pulled
inflation.
• Problem:
– Could cause unemployment
– Usually lead to budget surplus.
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• Solution:
Inflation Vs. Fiscal Policy
– Contractionary Fiscal Policy
➢Decrease government expenditure and/or
increase taxes
➢Reduce aggregate expenditure
➢Aggregate output decreases
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Inflation Vs. Fiscal Policy
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Automatic Stabilizers
• Definition:
– revenue & expenditure items in the federal budget that
automatically change with the state of economy and tend to
stabilize GDP.
• Example: during expansions, people are making more
money and when they pay income tax, government gets
more incomes.
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Taxes
• Net taxes (T) – taxes paid by firms & households to
the govt. minus transfer payments made to
households by the govt.
• Disposable income (Yd) – total income minus taxes.
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Government Spending
• Budget – difference between what it spends (G) and
what it collects in taxes (T).
budget = G − T
– If G > T, it is called budget deficit.
– If G < T, it is called budget surplus.
– If G = T, it is called balanced budget.
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Government in the Economy
• Relations between aggregate income, taxes,
consumption & saving:
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Equilibrium Output (3 sectors)
• Consumption function that takes into account of taxes:
• Aggregate Expenditure (AE) for 3 sectors economy:
• In equilibrium condition:
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Equilibrium Output (3 sectors)
Assuming in an economy:
C = 100 + 0.75Yd
I = 300
G = 300
T = 300
Compute the equilibrium output level for the
economy.
17
Equilibrium Output (3 sectors)
• Solution:
18
Equilibrium Output (3 sectors)
AE
Y
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Leakages/ Injections
Approach
• Taxes (T) & savings (S) are leakages from the flow
of income.
• Government spending (G) & planned investment
(I) are injections to the income flow.
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Equilibrium Output (3 sectors)
• Solution:
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Fiscal Policy at Work
• You are the senior economist in the country.
• Prime Minister seeks for your advice on how to
reduce the unemployment rate by increasing
aggregate output.
• A research shows that an acceptable
unemployment rate could be achieved only if
aggregate output (Y) increases to RM2000
compare to previous equilibrium level (RMxxxx).
• What would you suggest?
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First Choice
• Increase government spending (G) while tax (T)
remain unchanged.
• Question: How much should G increase?
• G multiplier: 1/MPS
• Calculate ΔG & G1 using
a) AE approach
b) Multiplier approach
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First Choice
• Solution – AE approach:
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First Choice
• Solution – Multiplier approach:
25
Second Choice
•
•
•
•
Decrease tax (T ) while government spending (G)
remain unchanged.
Question: How much should T decrease?
Tax multiplier:
− MPC
kT =
MPS
Calculate ΔT and T1 using
a) AE approach
b) Multiplier approach
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Second Choice
• Solution – AE approach:
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Second Choice
• Solution – Multiplier approach:
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Third Choice
•
•
•
•
balanced- budget.
Question: How much should G & T change?
Balanced-budget multiplier: 1
Calculate ΔG using
a)
b)
AE approach
Multiplier approach
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Third Choice
• Solution – AE approach:
30
Third Choice
• Solution – Multiplier approach:
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Summary: Fiscal Policy Multipliers
Policy stimulus
Government
spending
multiplier
Increase/ decrease in
the level of government
spending:
Tax multiplier
Increase/decrease in
the level of net taxes:
Balancedbudget
multiplier
Simultaneous
increase/decrease in
the level of government
spending & net taxes:
Multiplier
Final impact
on Y
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Self Practice
• Assuming in an economy:
C = 100 + 0.75Yd
I = 300
G = 300
T = 300
Now, government decides to have a budget surplus
where G increases by 200 and T increases by 300.
Calculate the new equilibrium output level.
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