Download Government intervention and fiscal policy

Government intervention
and fiscal policy
Adding a government to the
goods market equilibirum
Government intervention and fiscal policy

Today we examine a simple extension to
last week’s analysis of the equilibrium in the
goods market.


A specific agent is introduced (the government),
which controls two extra variables in aggregate
demand: taxes and expenditure
We analyse how the presence of the
government changes the situation in the
markets
Government intervention and fiscal policy

The debate about role of the government in
influencing the goods market equilibrium is
visible in the current affairs:


Most economies are in recession/depressed, with
a low level of output relative to their potential
As a result, most countries have put in place
“output stimulus plans”, such as the 800 bill $
US plan

There is currently a debate on the sustainability
of such deficits
Government intervention and fiscal policy

But there are questions around this:
 Why is it necessary for the government to



intervene is such circumstances (i.e. Not a
matter of ideology) ?
How big must the intervention be ?
Why does the debate around government
more expenditure vs. tax cuts matter ?
Simple models can actually explain all this
quite well...
Government intervention and fiscal policy
Aggregate demand and the government
The different multipliers
The role of the government in the
savings-investment gap
Aggregate demand and the government


The government controls two variables
that were omitted last week:
 Government spending G
 Taxes T
These variables represent the
government's budget:
 If G - T > 0 there is a budget deficit
 If G - T < 0 there is a budget surplus
 If G - T = 0 the budget is balanced
Aggregate demand and the government

These two variables usually enter
aggregate demand as follows:


First, government spending enters
aggregate demand directly:
Z=C+I+G
Second, taxes T are paid by agents out of
their income, thus reducing their
disposable income
C = C0 + c (Y – T )
Aggregate demand and the government

As a result, the detailed aggregate
demand equation becomes:
Z = C0 + c (Y – T ) + I + G


We still consider investment to be
exogenous (for the moment)
The equilibrium condition on the market
does not change: it still is Y = Z
Aggregate demand and the government
Aggregate demand as a function of income
Aggregate
Demand Z
Aggregate Demand (planned
expenditure)
Z = C0 + c (Y – T ) + I + G
mpc: 0<c<1
Autonomous demand (not a function of Y )
C0 - cT+ I + G
Income, output Y
Changes
from last
week
Aggregate demand and the government
Equilibrium on the goods market, with government
Aggregate
Demand Z
Effective expenditure
Y=Z
Aggregate Demand (planned
expenditure)
Z = C0 + c (Y – T ) + I + G
Keynesian
Equilibrium Output
45°
Y*
Income, output Y
Aggregate demand and the government


So the aggregate demand curve and the
market equilibrium diagram solve the
same way as last week.
This means that one can find the
equilibrium level of output Y* the same
way as we did last week
 Set Y = Z
 Solve for Y* by isolating output on the
left-hand-side of the equation
Aggregate demand and the government

We have the following market equation and
equilibrium condition
Z  C0  cY  T   I  G

Y  Z

Setting Y = Z
Y  C0  cY  T   I  G

Isolating Y on the left hand side
Y 1  c   C0  cT  I  G
Aggregate demand and the government

This gives the equilibrium level of output:
Multiplier
Y
1

I 1  c 

1
C0  cT  I  G 
Y
1 c
Autonomous
demand
(exogenous)
One can see at this point that the main effect of
the government intervention:


Is not really to change the size of the multiplier
The government, however, can influence the size
of the autonomous demand in the economy
Government intervention and fiscal policy
Aggregate demand and the government
The different multipliers
The role of the government in the
savings-investment gap
The different multipliers

Last week, we saw that there was an
investment multiplier ΔY/ΔI



In fact, there are several sorts of multipliers



Equal to 1/(1-c )
Referred to as “the” multiplier
Last week, investment was the only exogenous
variable
Introducing G and T means more multipliers
Will see some again when we introduce
international trade.
The different multipliers

The spending multiplier


Corresponds to the increase in output following
an increase in government spending G
Given equilibrium output:
1
C0  cT  I  G 
Y
1 c


It is equal to
Y
1

G 1  c
This is the same as last week’s investment
multiplier
The different multipliers

The tax multiplier


Corresponds to the change in output following
an increase in taxes T
Given equilibrium output:
1
C0  cT  I  G 
Y
1 c


It is equal to:
Y
c

T
1 c
This is a new multiplier, different from last week
The different multipliers

The tax multiplier
Y
c

T
1 c

This multiplier is negative
 An increase in taxes leads to a fall in output

It is smaller in absolute value than the spending
multiplier
c
1
1 c


1 c
Tax cuts aren’t as effective as government
spending in stimulating output.
The different multipliers

The tax multiplier

Let’s go back to the aggregate demand and the
equilibrium output to see why:
Z  C0  cY  T   I  G
Y


1
C0  cT  I  G 
1 c
Increased government spending G enters
aggregate demand directly, but tax cuts enter
indirectly, through disposable income (Y-T )
So some of the tax cut is directly saved, which
reduces the multiplier effect.
The different multipliers

Balanced budget multiplier


The fact that the tax and spending multipliers
are different sizes means that there is a balanced
budget multiplier
Let’s start with a balanced budget G=T
Y

1
C0  cT  I  G 
1 c
The net effect of a change in spending and taxes
is:
dY 
1
c
dG 
dT
1 c
1 c
The different multipliers

Balanced budget multiplier

In the case of a balanced budget increase we
have ΔG = ΔT
dY 
1
c
dG 
dT
1 c
1 c
c 
 1
dY  

dG
1 c 1 c 
dY 

1 c
dG
1 c
The balanced budget multiplier is equal to 1!
Government intervention and fiscal policy
Aggregate demand and the government
The different multipliers
The role of the government in the
savings-investment gap
The role of the government in the S-I gap

So we have established that the government
can change the equilibrium level of output:



By varying the level of its deficit (G-T )
Several policy options are available for “finetuning”: changes in taxes, in spending, even in
the absolute size of the budget.
But surely, budget deficits are a bad thing?


Like every economic agent, the state needs to
balance its books, so it should keep G=T
This is known as the “treasury view”
The role of the government in the S-I gap


But this view ignores the fact that the state
is a special agent, and that fiscal policy
plays a central role in the economy.
This can be understood by examining the
2nd interpretation we saw last week:


The Y=Z equilibrium condition can always be
interpreted as a savings = planned investment
condition
But first of all, we need to work out this alternative
equilibrium condition.
The role of the government in the S-I gap

Expenditure (Aggregate demand) is equal to:
Z= C + I + G

Income can be divided up into:
Y=C+S+T

At equilibrium we have Y=Z . This gives:
C+I+G=C+S+T
I + (G-T) = S
Planned private
investment

Public investment
Alternatively: G-T = S-I
Planned savings
The role of the government in the S-I gap
G-T = S-I

If I > S (planned investment higher then
planned savings)


The state can bring the economy to equilibrium
by running a surplus (G <T ), which supplies
extra (public) savings
If I < S (planned investment lower then
planned savings)

The state can bring the economy to equilibrium
by running a deficit (G >T ) which “mops up” the
excess savings with public investment
The role of the government in the S-I gap
G-T = S-I

What about the current situation?


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
Planned investment is at a record low: because of
the recession (and expected depression) firms
are cutting back on investment plans.
Planned savings are high: agents are anxious
about the future or realise the high levels of
private debt need to be paid back.
So large public deficits are needed to bring these
economies back to equilibrium
Trying to balance the budget NOW would only
prolong the situation (like in the 1930’s)