Fiscal Policy
Government spending, tax, and
budget balance
 Government
Spending: G
 Government Revenue: Tax
Government spending, tax, and
budget balance
 Deficit
=G-T
Two fiscal components in AE:
G and T
 AE
= C + I + G + X - IM
= a + b (Y - T ) + I + G + X - IM
Tax
 Lump-sum
Tax
– is a fixed amount tax, regardless of the
GDP level.
 Income
Tax
– Depends on the income level
Lump-sum Tax and its effect on AE
A
parallel shift in the AE line
Consumption function
in the Y-C Space
C’
C
C
Changes in T
C = ( a – bT) + b Y
a – bT
0
Y (GDP)
AE in the AE-Y space
AE
AE = C + I + G + X - IM
cut in T
0
Y
Example of a Model economy
C = 360 + 0.8 DI
I = 300
G = 200
X - IM = 0
T = 200
 Assume that the potential GDP is
4000
Example of a Model economy

Assume prices are fixed, what is the
equilibrium level of Y?
AE =360+0.8(Y-200)+300+200+0
= 0.8 Y + 700
Y = AE = 0.8 Y + 700
(1-0.8) Y = 700
Y* = 1/(1-0.8) X 700 = 5 X 700
= 3500
Example of a Model economy
 Assume
that the potential GDP is
4000
 But the current output is 3500
 Hence the recessionary gap is 500
Cut in Tax (lump-sum tax)
AE
AE’
AE
Cut in T
0
Y
Cut in Tax (lump-sum tax)
45 degree line
AE
AE’
AE
Cut in T
0
Y*
Y’
Y
Tax multiplier
 Tax
multiplier
Y*

T = -----T
 How big is the tax multiplier?
T 
Y
T
  MPC 
Y
G
  MPC   E
Tax multiplier
 For
T 
the oversimplified version
Y
T
  MPC 
1
1  MPC

 MPC
1  MPC
Effect of Tax Change on AE
 The
magnitude of shift in AE by a tax
cut is smaller as compared with
increase in G
 Why is smaller?
 Leakage from saving
Example
 Suppose
instead of increasing the
spending, the government decides to
cut the tax to close the recessionary
gap. By how much cut in tax can the
government close the gap?
Example of a Model economy
 Assume
that the potential GDP is
4000
 But the current output is 3500
 Hence the recessionary gap is 500
 Objective: close this recessionary
gap to achieve the full employment
 Two options: increase G or Cut in T.
Example of a Model economy
 Two
options: increase G or cut in T.
 If increase in G, how much?
 If cut in T, how much?
Example of a Model economy
 Increase
in G.
 What is the expenditure multiplier?
 MPC = 0.8
so expenditure
multiplier is 5
 Increase G by 100 would lead to an
increase in Y by 500, and close the
recessionary gap.
Example of a Model economy
 Cut
in T
 What is the tax multiplier: -4
Tax multiplier


1
1
T = - MPC X --------- = - 0.8 X -------- = -4
1 - MPC
1- 0.8
To increase GDP by 500, we need tax cut by
500 / -4 = - 125
Balanced budget multiplier
If the government simultaneously
increases its spending and tax by the
same amount so as to leave the
balance unchanged, will there be an
impact on the equilibrium GDP?

--- a net effect on GDP

Income Tax
 Depends
on the income. It increases
as income increases
 Income tax rate = t
 Its effect on AE
The slope of AE changes as tax
rate changes
Cut in in tax rate
AE
t=0
AE
AE’
b ( 1-t)
t = 0.20
increase in t
0
Y
Cut in tax rate
45 degree line
AE
AE’
AE
Cut in t
0
Y*
Y’
Y
Income Tax
 Equation
form
Let the income tax rate = t
Tax is
T = tY
 Consumption
C = a + b DI
= a + b (Y - tY)
= a + b (1-t) Y
Example
 Model
C = 360 + 0.8 DI
I = 300
G = 200
X - IM = 0
 With income tax rate
t = 0.25
Income Tax Model
Solve for equilibrium Y
C = 360 + 0.8 ( 1- 0.25 ) Y
= 360 + 0.6 Y
 AE = 360 + 0.6 Y + 300 + 200

= 860 + 0.6 Y
Notice that the slope of AE is flatter.
 Y* = 1 / (1-0.6) X 860
= 2.5 X 860 = 2150
Notice the expenditure multiplier
becomes 2.5, which is smaller.
Income tax
 With
income tax, the multiplier is
smaller because at each round of the
“trickling-down” process, there is a
leakage of income tax paid.
 This another reason why we called
1/(1-MPC) oversimplified multiplier.
Why changes in T is
less effective than G
in economic recession
 Why
changes in T is less effective
than G in stimulating economy in
economic recession?
 Tax multiplier is smaller
 Consumption is insensitive to a tax
cut so long as people remain
pessimistic about future
Difficulties to design a precise
policy
 All
the variables are changing day by
day;
 the precise value of MPC is unknown,
 the precise value of Yp is unknown,
 the time lag for the policy to take
effect is unknown,
 the shape of AS is unknown thus the
inflation side-effect caused by the
expansionary tax policy is unknown.
Twin deficits
 The
trade deficit is related to our
budget deficit
 We have $500 billion trade deficit,
and $1.5 trillion budget deficit.
Breakdown of the deficit
Breakdown of the deficit
• Compared with the October-June period of fiscal 2008, during the
first nine months of fiscal 2009:
• --Revenues plunged $345 billion, or 17.8 percent;
• --Spending soared $455 billion, or 20.5 percent;
• --Defense spending increased 7.5 percent to $474 billion;
• --Spending on food stamps increased 36.8 percent to $40 billion;
• --Medicaid spending increased 23 percent to $186 billion;
• --Unemployment benefits increased 165 percent to $77 billion;
• --The Troubled Asset Relief Program, which began in October, has
cost taxpayers an estimated $147 billion;
• --Bailing out Fannie Mae and Freddie Mac has cost $85 billion.
Twin deficits
Y = C + I + G + (X - IM)
Y = C + S + T
Combine the two accounting identities, we
have
 C + I + G + (X - IM) = C + S + T
 IM - X = (G – T) + (I – S)
 Trade deficit
= Government budget deficit
+net private saving deficiency

How should we reduce trade deficit
 Government
budget deficit
= net private saving + trade
deficit
 According to the twin deficits model,
we need to reduce the government
budget deficit G - T
 You either cut the government
spending or raising tax
How should we reduce trade deficit
 According
to the Keynesian theory
(the balance budget multiplier)
raising tax is probably the better
idea to balance the budget but
stimulate the economy
 But there is a big political hurdle to
raise tax.
Health reform bill and budget
 According
to the Congressional
Budget Office’s estimate, the bill will
cut the budget deficit by 138 billion
dollars a year.
 CBO is a non-partisan, independent
office, reporting to the Congress.
The Republicans also cite often the
figures by CBO to criticize
Democrats.
Supply-side economics
 Reaganomics
 Supply-side
economics
 Supply-side tax cuts
 Shift focus from AD to AS
Supply-side economics
 Supply-side
tax cuts
 cutting income tax to induce people
to work longer, and
 giving tax incentive to encourage
investment and research
 Remarks