Download Lecture 20

L11200 Introduction to Macroeconomics 2009/10
Lecture 20:
Government Expenditure
Reading: Barro Ch.12
18 March 2010
Government Expenditure
• Model so far considered household sector
only
– In reality, governments are big players in the
economy
– Government spending = 30-50% GDP
• Begin with overview of U.K. government
spending from Financial Times
– http://media.ft.com/cms/2ae20b78-a20b-11de-81a6-00144feabdc0.swf
Government Budget Constraint
• Governments, like households, have a budget
constraint
• Government one-period budget constraint:
Gt  Vt  Tt  (M t  M t 1 ) / Pt
government spending + government transfers = tax revenue + real revenue from money
creation
• In practice, revenue from money creation is
very small, so disregard this
Government Activity
• Explaining the budget constraint
– Governments tax households to raise income
– They spend some money directly on goods and
services (e.g. national health service) on behalf of
the population
– They provide transfers of money directly to some
households (e.g. benefits)
– Initially assume government spending /transfers
yield no utility to households
Household’s Budget Constraint
• Government taxes and transfers alter
household budget constraint
– If household receive benefits (i.e. transfer of
money from the government) they are better off
– If they have to pay tax, they are worse off
– So net effect depends on combination of these
factors
Household’s Budget Constraint
• Modified budget constraint (in present value)
• V=transfer from govt. T=tax paid to govt.
• Taxation is just a lump-sum per period
C1  C2 / (1  r1 )  ...  (1  r0 )  ( B0 / P  K0 )  (w / P)1  L1s  (w / P)2  Ls2 / (1  r1 )  ...
(Vt  T1 )  (V2  T2 ) / (1  r1 )  (V3  T3 ) /[(1  r1 )  (1  r2 )]  ...
present value of consumption = value of initial assets + present value of wage incomes
+ present value of transfers net taxes
Taxes and Transfers
• So impact of household depends on net effect
– If household is net recipient of transfers, it is a net
beneficiary from the government
– If household is a net tax payer, it is a net
contributor to the government
• Government intervention gives rise to an
income effect
– Net Beneficiaries: positive (more consumption,
more leisure) vice versa for net contributors
Permanent Change in Policy
• Suppose government decides to increase
spending by 1 unit per year, forever
– Income falls permanently, so consumption falls
permanently by 1 unit per year
– Does spending have any impact on output,
employment, capital investment?
Effect on Output, Capital, Labour
• Increased government spending
– Decreases resources available for households to
spend
– Doesn’t change MPK, R/P or MPL, w/P – no
impact on demand for labour or capital
– If K and L are fixed (as in earlier model) – no
impact on supply of labour or capital
– So no change in household’s decision about
output, Y, or capital use or employment
Effect on Interest Rates
• Equilibrium condition for interest rates:
r  ( R / P)     ( )
Real rate of return on bonds = real rate of return from owning capital
• Return to capital unchanged
– Hence return to bonds unchanged
– So only effect of increase in government spending
by one unit is to decrease household
consumption, permanently, by one unit
Temporary Change in Policy
• If increase in expenditure is temporary
– Household resources fall for one period, then
increase back to original level
– Effect on lifetime wealth much smaller, so effect
on current consumption is much smaller
– Household smooth over change in government
spending in the same way they smooth over
temporary change in income.
Temporary Real Effects
• As with a permanent change, temporary
change leaves most real activity unaffected
– But as consumption fall is smaller, some
investment is sacrificed
Y  C  I G
– Permanent increase in G caused 1:1 fall in C
– Temporary increase in G causes <1 fall in C, so
investment falls to offset G
Summary
• Government large player in economy
– Spends ~ 30% GDP, employs ~25% workforce
– In simple model, government activity lowers
household resources
– Similar to permanent / temporary change in
income
• So far, simple treatment of taxation
– Next time: what to tax and why