Notes for Lecture 18: Macro 2: Fiscal Policies, Government Spending and Taxation
[with models] [February 23, 2010]
Note: Some of the content in Lecture 17 is presented in Lecture 18. Some of the content in
Lecture 18 is contained in Lecture 19.
Economic Concepts:, family consumption and savings functions, marginal propensity to
consume, average propensity to consume, marginal propensity to save, average propensity
to save, investment-savings model, desired investment equals desired saving, undesired
inventory increases and decreases, aggregate expenditure model [AE], linear consumption
function, insufficient aggregate demand, injection necessary to reach full employment in AE
model, investment multiplier and the simple investment multiplier process, discretionary
fiscal policy versus fiscal policy, effectiveness of discretionary fiscal policy, four macro
economic models to show a fiscal/monetary injection/withdrawal.
Purpose of Monetary and Discretionary Fiscal Policy [DFP]
The primary purposes of monetary policy [Lecture 17] and discretionary fiscal policy are to
achieve full employment with price stability.
Through the transmission mechanism [analyzed in Lecture 18], it was shown how monetary
policy worked when the central bank undertook open market transactions [OMO]. When the
central bank [Bank of Canada] buys/sells Government of Canada bonds, the central bank’s
intention is to increase/decrease the cash reserves of the chartered banks. When chartered banks
have increased cash reserves, they will be able to offer new loans to the business sector which, in
turn, would raise the level of investment and through the investment multiplier [part of this lecture]
would increase the level of employment and real output in the economy.
In this lecture [and the following lecture], it will be shown that discretionary fiscal policy, which
should be co-ordinated with monetary policy, would also work to impact upon GDP, employment
and the price level.
Discretionary fiscal policy [DFP] is that component of total fiscal policy intended to achieve full
employment with price stability. In contrast, fiscal policy refers to any government outlay
[government spending on final goods and services and transfer payments to the private sector] and
tax revenue. For example, fiscal policy would include the fiscal commitment for the military
sector, which would not be included within discretionary fiscal policy. Discretionary fiscal
policy works primarily through increases/decreases in government expenditure on final goods and
services and through increases/decreases in taxation which are usually presented in the annual
Monetary policy and discretionary fiscal policy should work in a combined manner to restrict
economic activity in the economy when inflationary pressures occur [i.e., the economy is
overheated] and to expand economic activity in the economy when too high a level of
But the most important economic goal, in the long run, is to achieve increases in output per
person hour – labour productivity.
The Transmission Mechanism [Outlined in the Notes for Lecture 17]
Carried over from the previous lecture were the impacts of OMO by the central bank which finally
impacted upon the level of real national income [Y] and employment. The transmission model
was described in the lecture notes for Lecture 17 but was presented during this lecture.
The Bank Rate and Monetary Policy [continuation of Lecture 17]
Referring again to content related to Lecture 17, the Bank Rate plays an important role in
monetary policy, primarily as a signal towards changes in the direction of monetary policy. The
Bank Rate is the rate at which chartered banks can borrow at the Bank of Canada [central bank].
However, in Canada this is rarely undertaken i.e., only if a chartered bank is temporarily short of
cash reserves. Thus, changing the Bank Rate is mainly a signal about future monetary policy.
When the Bank Rate changes, then the central bank would also be engaged in the appropriate open
market operations. [Examine this effect through the transmission mechanism].
Fixed Foreign Exchange Rate Regime and Monetary Policy [continuation of
Assume that a country has two economic problems: a balance-of-payments deficit together with
too high a rate of unemployment. Also assume that price stability exists.
Now the country has a choice upon which economic problem is more important. Almost always,
the international economic problem takes precedence. In the above case, the government/central
bank’s action would be to raise short term interest rates to attract International Portfolio
Investment to attract foreign savings to the country.
However, this is a problem for monetary policy. An ‘easy’ monetary policy, intended to stimulate
the economy, would require a reduction in interest rates. [Examine the transmission mechanism.]
In effect, monetary policy could not be used to stimulate the economy.
Thus, when the above two economic problems surface together and the country has a fixed
foreign-exchange rate regime, then monetary policy can not play its normal role: in fact, monetary
policy must remain unchanged. In this case, discretionary fiscal policy would be the sole
government instrument to bring the economy to full employment.
However, if the country had a flexible foreign-exchange rate, then monetary policy would be fully
available, together with DFP, to induce incremental output and employment.
The AD/SRAS Model [continuation of Lecture 17]
The AD/SRAS model was developed in the previous lecture and relates the price level in the
economy to real GDP. This model holds for an economy with too low a level of real output such
that full employment has not been attained. This model also holds for situations in which the
economy experiences inflation.
With respect to inflation, a cost-push inflation is shown in the AD/SRAS curve diagram via an
upward shift in the SRAS curve which would lead to a higher price level. A demand-pull inflation
would be represented by a significant shift to the right in the AD curve through either expansion
monetary policy or expansionary fiscal policy, such that the price level would increase.
The Family Consumption and Savings Functions and Associated Curves
Assume that the country has a simple economy in which there is no government and no
international trade. In this simple economy there would be three macro economic variables:
consumption [C] and investment [I] together with savings [S].
The family consumption function relates the level of desired consumption for each potential level
of disposable income for the family. In the lecture analysis, the MPC and APC and the break-even
point were discussed.
Then, using the definition, Sp = Yd - C, the same family’s personal savings function were derived.
In the lecture analysis the following terms were defined: MPS, , APS and dissaving.
The Investment/Savings Equilibrium in a Price Stable Economy
The economy’s aggregate savings function [personal savings only by assumption] is represented
by a relatively flat straight line which moves from negative saving [discasing] to positive levels of
saving at different levels of NDP [net domestic product] or real national income.
In this simple model, it is assumed that entrepreneurs wish to spend a constant [autonomous]
amount on investment [e.g., new housing, plants and machinery and equipment] at each level of
GDP – thus, the desired investment function is independent of the level of Y and is represented by
a horizontal perfectly elastic straight line.
The country achieves equilibrium in this model where the desired investment curve intersects the
desired savings curve. At this level of Y, businesses and households would wish to save the same
amount as entrepreneurs wish to invest.
If the economy achieves a level of Y which exceeds the equilibrium level of Y, then the country
experiences unwanted/unintended/undesired inventory accumulation i.e., products produced but
not sold but which were intended to be sold. As a result, production levels would be reduced
which would send the economy towards its equilibrium level and result in fewer final goods and
services and a greater level of unemployment.
The savings/investment model was introduced in Lecture 17 as the third diagram in the
transmission mechanism as presented in the lectures.
Conversion from Investment/Savings Model to Aggregate Expenditure Model
The country’s aggregate savings function can be converted to aggregate consumption through the
definitional equation: Sp = Yd - C.
In the new diagram, in which desired consumption and desired investment are presented on the
vertical axis, the consumption function will now be presented by a constant and a induced
proportion of consumption which depends upon the value of MPC and the level of Y.