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ECON1102 Lecture Notes - Lecture 5: Fiscal Policy, Government Budget Balance, Budget Constraint

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School
UNSW, UNSW Sydney
Department
Economics
Course
ECON1102
Professor
Arusha Cooray

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Tuesday, 10 April 2018
Week 5: Government Sector and Fiscal Policy
Key Ideas !
-Fiscal policy and fiscal instruments!
-G and T in income-expenditure model!
-Fiscal multipliers!
-Balanced budget multiplier!
-Fiscal policy and output gaps!
-Automatic stabilisers!
-Discretionary fiscal policy!
-Government budget constraint !
-Public debt!
-4-sector income-expenditure model!
Fiscal Policy!
-Does it matter in a recession?!
-whether the government sends you a cheque or gives you a tax cut !
-fiscal multipliers and their magnitude.!
Instruments of Fiscal Policy!
-Government expenditure: current goods and services, investment and
infrastructure !
-Taxes (direct, indirect) - income taxes, consumption taxes (GST) !
-Transfer payments - unemployment benefits, pensions!
Fiscal Policy in Income-Expenditure Model!
-Government decisions about G and T can affect the level of output in the
economy !
-Assume a closed economy (X=M=0)!
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Tuesday, 10 April 2018
-PAE = C + I^P + G !
-Direct role for government expenditure G to affect PAE!
-What about taxes T?!
-C = C0 + c(Y-T) !
Tax Function!
-What determines the level of tax revenue? !
-Role for GDP: T= T0 +tY !
-Autonomous component to taxes given by T0 !
-Induced component that depends on Y !
-t = marginal tax rate !
-change in T/change in Y = t !
-Gives the change in tax receipts for a change in national income.!
Consumption function and Tax function !
C = C0 + c(Y-T)!
T = T0 + tY !
C=C0 + c(Y-T0-tY)!
C=C0-cT0+c(1-t)Y!
- Three sector model!
PAE = C + I^P + G!
C = C0 + c(Y-T)!
I^P=I0!
G=G0 (assume government spending is autonomous/exogenous)!
T=T0+tY!
PAE = [C0 - cT0 + I0 +G0] +c(1-t)Y!
Y = PAE!
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Tuesday, 10 April 2018
Equilibrium in Three Sector Model !
Y = [C0 -cT0+I0+G0] + c(1-t)Y!
Y[1-c(1-t)]= [C0 -cT0+I0+G0]!
Y^e = 1/[1-c(1-t)] x [C0 -cT0+I0+G0]!
Fiscal multipliers in Three Sector Model!
Which has a larger effect on GDP?!
-Exogenous tax cut or increase in government spending?!
-Equal size changes in G and T !
-Increase G by 100 and cut T by 100 !
-E.g. c=0.6 and t=0.3!
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Document Summary

Whether the government sends you a cheque or gives you a tax cut. Government expenditure: current goods and services, investment and infrastructure. Taxes (direct, indirect) - income taxes, consumption taxes (gst) Government decisions about g and t can a ect the level of output in the economy. Pae = c + i^p + g. Direct role for government expenditure g to a ect pae. Autonomous component to taxes given by t0. Change in t/change in y = t. Gives the change in tax receipts for a change in national income. Pae = [c0 - ct0 + i0 +g0] +c(1-t)y. Equal size changes in g and t. Increase g by 100 and cut t by 100. Government purchases of goods and services are a component of pae and therefore have a direct e ect on y. Taxes and transfer payments a ect the level of disposable income (y-t) received by the private sector.

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Related Questions

1.Ceteris paribus, if the U.S. federal government reduces its budget deficit which of the following will be observed?

Answer

a.

The aggregate demand curve will shift to the right.

b.

The economy will always approach potential GDP.

c.

The marginal propensity to consume will increase.

d.

The average price level will increase.

e.

The aggregate demand curve will shift to the left.


2. If the government wants to close a GDP gap, it can:

Answer

a.

lower government spending on social security.

b.

adopt contractionary fiscal policies to control inflation.

c.

increase its budget deficit.

d.

repay its borrowings.

e.

raise both direct and indirect tax rates.


3. Suppose the short-run equilibrium level of income exceeds the full employment level of income and there is high inflation. Hence, the government decides to implement a fiscal policy that will act to reduce national output and price level. This can be accomplished by:

Answer

a.

lowering average tax rates such that aggregate supply is increased.

b.

increasing government spending such that aggregate expenditures are increased.

c.

increasing transfer payments such that aggregate expenditures decline.

d.

raising taxes and government spending by the same amount such that aggregate supply is decreased and aggregate demand is increased.

e.

decreasing government spending such that aggregate demand is reduced.


4. A drop in investment spending caused by increased government budget deficits is referred to as:

Answer

a.

the multiplier effect.

b.

crowding out.

c.

an expansionary gap.

d.

the paradox of thrift.

e.

the Ricardian equivalence.

5. Discretionary fiscal policy is best defined as:

Answer

a.

the deliberate manipulation of the money supply to expand the economy.

b.

the deliberate change in tax laws and government spending to change equilibrium income.

c.

the policy action taken by the Congress to reduce the federal budget deficit.

d.

the arbitrary fluctuation in tax laws and budget requirements.

e.

the automatic change in certain fiscal instruments when real GDP changes.


6. Which of the following can be considered as an automatic stabilizer in the economy?

Answer

a.

Money supply

b.

Disposable income

c.

Real exchange rate

d.

Real interest rate

e.

Unemployment insurance


7. Which of the following is true about automatic stabilizers?

Answer

a.

When income rises, automatic stabilizers increase/boost spending.

b.

Automatic stabilizers are a part of discretionary fiscal policy.

c.

An automatic stabilizer is any program that responds to fluctuations in the business cycle in a way that moderates the effects of those fluctuations.

d.

Any kind of trade policy adopted by the government will be considered as an automatic stabilizer.

e.

The interest rate is an example of an automatic stabilizer.


8. Increased budget deficits

Answer

a.

can cause interest rates to increase and hence decrease net exports

b.

have no effect on net exports

c.

can cause interest rates to decrease and hence increase net exports

d.

never impose additional interest costs on the government


9. The Ricadian Equivalence implies that when financing additional government expenditures

Answer

a.

there is no difference between increasing current taxes or borrowing now and increasing taxes in the future because consumption will decrease either way.

b.

there is no difference between increasing current taxes or borrowing now and increasing taxes in the future because consumption will increase either way.

c.

increasing borrowing is the best option

d.

increasing current taxes is the best option


10. Assuming no effects on aggregate supply, if the government increases government spending and decreases taxes in an attempt to prevent a possible recession, aggregate demand will shift to the ____, the price level will either remain constant or ____, and the level of real GDP will ____.

Answer

a.

right; decrease; increase

b.

right; decrease; decrease

c.

left; decrease; decrease

d.

left; increase; increase

e.

right; increase; increase


11. For a hypothetical economy, the MPS is 0.08 and the MPI is 0.17. If government spending increases by $35 and taxes increase by $35, what will be the net effect on equilibrium income?

Answer

a.

A decrease of $35

b.

An increase of $105

c.

An increase of $35

d.

A decrease of $105

e.

A decrease of $15

1.

12.12. The term fiscal policy refers to

Answer

a.

the adjustment of the GDP for inflation.

b.

the purchase and sale of U.S. government securities to regulate the money supply.

c.

the use of government spending and taxation to influence the level of economic growth and inflation.

d.

the use of fines to penalize unfair business practices.

e.

a policy action by Congress to overrule unpopular budget cuts by the president.


13. If aggregate demand intersects aggregate supply in the vertical range of the aggregate supply curve, then, other things equal, an increase in government spending will

Answer

a.

raise the price level and leave real GDP unchanged.

b.

raise real GDP by the amount indicated by the government spending multiplier and leave the price level unchanged.

c.

raise both real GDP and the price level by a multiple of the initial spending increase.

d.

have no effect on real GDP or on the price level, because all private investment will be crowded out.

e.

lower real GDP by an amount equal to the spending increase and reduce inflation.

14. Which of the following is not a means to finance government spending?

Answer

a.

Government subsidies

b.

Government debt

c.

Capital gains taxes

d.

Personal income taxes

e.

Money creation


15. An automatic stabilizer is

Answer

a.

a change in government spending aimed at achieving a policy goal.

b.

an element of fiscal policy that automatically changes in value as real GDP changes.

c.

an element of monetary policy that automatically changes in value as real GDP changes.

d.

a decrease in tax rates as the economy moves into a recession.

e.

a deliberate change in taxation aimed at increasing real GDP.


16. Budget deficits tend to grow during recessions because

Answer

a.

real GDP growth is zero, which causes neither tax receipts nor government expenditures to grow.

b.

real GDP growth is positive, which reduces both tax receipts and transfer payments.

c.

real GDP growth is negative, which reduces transfer payments in relation to tax receipts.

d.

real GDP growth is negative, which reduces tax receipts in relation to government expenditures.

e.

real GDP growth is positive, which increases tax receipts in relation to government expenditures.

The Modified Keynesian Model

Y = C + I + G + X – IM … equilibrium condition in a 4-sector model where:

C = 150 + 0.9DI … consumption function

I = 50 … autonomous investment

G = 100 … autonomous government spending

X = 200 … autonomous exports

IM = 100 … autonomous imports

And also:

DI = Y – T + Tr T = 0 … autonomous taxes

Tr = 0 … autonomous transfer payments

YF = 5000 … full-employment Y

1. Solve for the equilibrium level of real output/income (Y*) in this economy.

2. Given the model above, net exports equal $________. Does this represent a trade deficit or trade surplus?

3. Given the model above, the federal budget has a (deficit/surplus) equal to $________.

4. What is the value of the MPC? … the value of the MPS?

5. Calculate the “oversimplified” expenditure multiplier.

6. Suppose that full-employment (YF) equals $5000. Is there a recessionary or inflationary output gap?

7. (Refer to question “6”.) How much is the gap equal to?

8. Suppose the government chooses to eliminate the gap by using expansionary fiscal policy (i.e., increasing G). Given the numbers above, by how much would government spending (G) need to increase to achieve the goal of full-employment?

9. Suppose instead that the government decided to lower taxes to eliminate the output gap in question “6”. How much would taxes need to fall to achieve the goal of full-employment?

10. Which action (raising G or lowering T) has the largest effect on the federal budget deficit and the national debt?

11. Suppose the national debt equaled $6000 before the tax cut (refer to question “9”). What would be the value of the national debt after this policy action?