Economics
TENTH EDITION
by David Begg, Gianluigi Vernasca, Stanley
Fischer & Rudiger Dornbusch
Chapter 17
Fiscal policy and foreign
trade
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Some key terms
• Fiscal policy
– the government’s decisions about spending
and taxes
• Stabilisation policy
– government actions to try to keep output close
to its potential level
• Budget deficit
– the excess of government outlays over
government receipts
• National debt
– the stock of outstanding government debt
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Government in the incomeexpenditure model
• Direct taxes
– affect the slope of the consumption
function
– and hence the slope of the AD
schedule.
• Government expenditure affects the
position of the AD schedule.
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Fiscal policy
45o line
AD1
AD0
Y0
Y1
Income,
output
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This seems to suggest
that the government
could influence
aggregate output in the
economy by raising AD
from AD0 to AD1,
thus raising equilibrium
output from Y0 to Y1.
But this ignores some
important issues –
prices, interest rates, and
the need to fund the
government spending.
The government budget
The budget deficit = total government spending, minus total tax
revenue.
If government spending is
independent of income,
Balanced
budget
but net taxes depend
on income,
then the budget will be
in deficit at low levels of
income but in surplus at
high levels.
G
Y0
The balanced budget multiplier states that an
increase in government spending plus an equal
increase in taxes leads to higher equilibrium output.
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NT
Income, output
Deficits and the fiscal stance
• The size of the budget deficit is not a good
measure of the government’s fiscal
stance.
• The structural budget shows what the
budget would have been if output had
been at the full-employment level.
• The inflation-adjusted budget uses real not
nominal interest rates to calculate
government spending on debt interest.
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Automatic stabilisers
• mechanisms in the economy that
reduce the response of GNP to shocks
– for example, in a recession:
•payments of unemployment
benefits rise
•and receipts from VAT and
income tax fall
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Limits on active fiscal policy
Why can’t shocks to aggregate demand immediately
be offset by fiscal policy?
• Time lags: it takes time
– to diagnose the problem
– to take action
– for the multiplier process to operate
• Uncertainty
– the size of the multiplier is not known
– aggregate demand is always changing
• Induced effects on autonomous demand
– changes in fiscal policy may induce offsetting
effects in other components of aggregate demand
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Limits on active fiscal policy (2)
Why doesn’t the government expand fiscal policy
when unemployment is persistently high?
• The budget deficit
– concern about inflation if the budget
deficit grows
• Maybe we’re at full employment!
– unemployment may be (at least partly)
voluntary
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Foreign trade and income
determination
• Introducing exports (X) & imports (Z)
• Trade Balance
– the value of net exports (X - Z)
• Trade Deficit
– when imports exceed exports
• Trade Surplus
– when exports exceed imports
• Equilibrium is now where
– Y=C+I+G+X-Z
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Exports, imports & the trade
balance
Assume that exports
are independent of
income,
Imports
Exports
but that imports
increase with income.
At relatively low income,
exports exceed imports
– there is a trade surplus.
Y*
At higher income levels, there is a trade deficit.
There is trade balance at income Y*, but there is no
guarantee that this corresponds to full employment.
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Income
Foreign trade and the multiplier
• The marginal propensity to import
– is the fraction of additional income that
domestic residents wish to spend on
additional imports.
• The effect of foreign trade is to reduce the
size of the multiplier
– the higher the value of the marginal
propensity to import, the lower the value
of the multiplier.
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Some maths: The multiplier
Equilibrium is where:
Y* = C + I + G + X – Z
where C = A + c(1-t)Y and Z = zY.
c = marginal propensity to consumer; t = the tax
rate and z the marginal propensity to import.
Hence:
Y* = [A + G + X + I] + c(1-t)Y – zY
Equilibrium dictates Y*=Y and hence:
Y* = [A + I + G + X ]/[ 1 – c(1-t) + z ]
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Y* = [A + I + G + X ]/[ 1 – c(1-t) + z ]
• Equilibrium output is the product of autonomous
spending - autonomous consumption demand A,
plus injections from investment, government
spending, and exports
• and the multiplier {1 / [ 1 – c(1-t) + z ]}
• In a small open economy, the marginal propensity
to import z will be much higher than in a large
closed economy such as the United States.
• Hence the multiplier will be lower in Belgium than
in the USA.
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