TheGovernmentSector

3.9 :

IncomeTaxesandAutomaticStabilizers
Theproportionalincometaxisoneexampleoftheimportantconcept
ofautomaticstabilizers.
Automaticstabilizer
Somepoliciesdesignedtoreducethelagsassociatedwith
stabilizationpolicy policiesthatstimulateordepresstheeconomy
whennecessarywithoutanydeliberatepolicychange
Anymechanismintheeconomythatautomatically thatis,
withoutcasebycasegovernmentintervention reducestheamount
bywhichoutputchangesinresponsetoachangeinautonomous
demand

AutomaticStabilizers
Examples:(i)Thesystemofincometaxesautomaticallyreducestaxes
whentheeconomygoesintorecession:withoutanychangeinthetax
law,individualsandfirmspaylesstaxwhentheirincomefalls.
Inthepresenceofautomaticstabilizersweshouldexpectoutputto
fluctuateless thanitwouldwithoutthem.
(ii)Unemploymentinsuranceandwelfaresystemautomaticallyraise
transfer paymentswhentheeconomymovesintoarecession.
Thismeansthatdemandfallsless whensomeonebecomes
unemployedandreceivesbenefitsthanitwouldiftherewereno
benefits.Thismakesthemultipliersmaller andoutputmorestable.

EffectsofaChangeinFiscalPolicy

3.9 :

Q:Whyisthemultiplierfortransferpaymentsmallerthanthatfor
governmentpurchasesbyafactor ?
A:BecausepartofanyincreaseinTR issaved.

EffectsofaChangeinFiscalPolicy
Q:Ifthegovernmentraisesmarginaltaxrates,whatwillhappen?
A:Twothingshappen.
(i)Directeffect:Aggregatedemandwilldecrease sincethehigher
taxesreducedisposable income andthereforeconsumption.
(ii)Indirecteffect:Themultiplierwillbesmaller,soshockswillhavea
smaller effectonaggregatedemand.

TheBudget
Overthelongsweepofhistory,thefederalgovernmenttypicallyran
surplusesinpeacetimeanddeficitsduringwars.
Question:Isthereareasonforconcernoverabudgetdeficit?
Wedealwiththegovernmentbudget,itseffectonoutput,andthe
effectsofoutputonthebudget.
Budgetsurplus(BS):
3.10 :

3.10 ,

TheBudget

3.10 ,

3.10 :

Thebudgetsurplusistheexcess ofgovernmentrevenues(taxes)over
itstotalexpenditureconsistingofpurchasesofgoods
and
services
andtransferpayments.
Thebudgetsurplusisapositive functionofthelevelofincome for
givenG,TR,andincometaxrate,t.

Figure 3.4:TheBudgetSurplus

TheBudget
Atlowlevelsofincome,thebudgetisindeficit (thesurplusis
negative)becausegovernmentspendingexceedsitstaxrevenues.
Athighlevelsofincome,thebudgetisinsurplus.
Q:Doesanincreaseingovernmentpurchases(G)reducethebudget
surplus?
A:Increasedgovernmentpurchasesreduce surplusorincrease
deficit.However,theincreasedgovernmentpurchaseswillcausean
increaseinincome andthereforeincreasetax revenues.

TheBudget

3.9 :

TheBudget

Therefore,anincreaseingovernmentpurchaseswillreduce the
budgetsurplus(orincrease thebudgetdeficit).
Q:Doesanincreaseinthetaxrateincreasethebudgetsurplus?
A:Infact,anincreaseinthetaxrate,keepingG andTR constant,
increases thebudgetsurplus,despitethereductioninincome thatit
causes.

AlternativeWayofThinkingaboutGoodsMarketEquilibrium
Anequivalentwayofthinkingaboutgoodsmarketequilibrium
focusesoninvestmentandsaving.
Savingisthesumofprivate savingandpublic saving.

Privatesavingsrate

Saving Investment
If
, publicsavingispositive
Thegovernmentrunsabudgetsurplus.
If
, publicsavingisnegative
Thegovernmentrunsabudgetdeficit.

3.11 :

Saving Investment
Equilibriumconditioninthegoodsmarket:
Subtract
frombothsidesandmoveC totheleftside:

3.12

Saving Investment

3.12 :

Eq(3.12)saysthatequilibriuminthegoodsmarketrequiresthat
investment equalssaving.Whatfirmswanttoinvest mustbeequal
towhatpeopleandgovernmentwanttosave.
Twoequivalentwaysofstatingtheconditionforequilibriuminthe
goodsmarket:
Production(Y)=Demand(Z) Investment(I)=Saving(S)

Saving Investment
Giventheirdisposableincome,onceconsumershavechosen
consumption,theirsavingisdetermined,andviceversa.

3.13

Marginalpropensitytosave (MPS):Howmuchofanadditionalunitof
incomepeoplesave

Saving Investment
Inequilibrium,

1
1

3.14

TheParadoxofSavingorTheParadoxofThrift
Virtuesofthrift Thosewhospendalltheirincomearecondemned
toenduppoor.Thosewhosavearepromisedahappylife.
Supposethat,atagivenlevelofdisposableincome,consumers
decidetosavemore;consumersdecrease ,thereforedecreasing
consumptionandincreasingsavingatagivenlevelofdisposable
income.
Q:Whathappenstooutputandtosaving?
A:Equilibriumoutputfalls:Aspeoplesave moreattheirinitiallevel
ofincome,theyreducetheirconsumption.

TheParadoxofSavingorTheParadoxofThrift
Butthisdecreasedconsumptiondecreasesdemand whichdecreases
production.

1
from . 3.13

ishigher(lessnegative):consumersaresavingmore atanylevel
ofincome;thistendstoincreasesaving.But,ontheotherhand,their
incomeY islower:Thisdecreasessaving.
Neteffect?
Accordingto
3.12 ,
.
Byassumption,investmentdoesnot change:
.
NordoT orG orTR.

TheParadoxofSavingorTheParadoxofThrift
Inequilibrium,privatesavingcannot change,either.
Althoughpeoplewanttosavemoreatagivenlevelofincome,their
incomefalls byanamountsuchthattheirsavingisunchanged.
Thismeansthataspeopleattempttosavemore,theresultisbotha
declineinoutput andunchanged saving.
Thissurprisingpairofresultsisknownastheparadoxofsaving.
Awarning:Policiesthatencouragesavingmightbegoodinthe
medium runandinthelong run,buttheycanleadtoafallindemand
andsoinoutput,andperhapsevenarecession,intheshort run.

IstheGovernmentOmnipotent?
Q:Canthegovernmentreallychoosethelevelofoutputitwant?
A:Obviouslynot!
Changinggovernmentspendingortaxesisnoteasy.GettingtheU.S.
Congresstopassbillsalwaystakesthetime.
Investmentandexportsaremorelikelytorespondinavarietyof
ways.Someoftheincreaseddemandbyconsumersandfirmswillnot
befordomesticgoodsbutforforeign goods.
Theexchangeratemaychange.
Alltheseresponsesmakeitharderforthegovernmenttoassessthe
effectsofitspolicieswithmuchcertainty.

IstheGovernmentOmnipotent?
Expectations arelikelytomatter.Forexample,thereactionof
consumerstoataxcutislikelytodependonwhethertheythinkof
thetaxcutastemporary orpermanent.Themore theyperceivethe
taxcutaspermanent,thelarger willbetheirconsumptionresponse.
Achievingagivenlevelofoutputcancomewithunpleasantside
effects.Tryingtoachievetoohighalevelofoutputcanleadto
increasinginflation.
Cuttingtaxesorincreasinggovernmentspending,asattractiveasit
mayseemintheshortrun,canleadtolargerdeficits andan
accumulationofpublic debt.Alargedebthasadverse effectsinthe
long run.

IstheGovernmentOmnipotent?
Inshort,thepropositionthat,byusingfiscalpolicy,thegovernment
canaffectdemandandoutputintheshortrunisanimportantand
correctproposition.
Butaswerefineouranalysis,wewillseethattheroleofthe
governmentingeneral,andthesuccessfuluseoffiscalpolicyin
particular,becomesincreasingly difficult.

MarketforGoodsintheClassicalModel
Q:Whatensuresthattheamountofconsumption ,investment
,andgovernmentpurchase
equalstheamountofoutput
produced
intheclassicalmodel?
A:Intheclassicalmodel,theinterest rate playsacrucialroleof
equilibratingaggregatesupplyandaggregatedemand.
Theclassicaleconomistsbelievethatahigher (lower)interestrate
encourages (discourages)savinganddiscourages (encourages)
consumption.

EquilibriumintheMarketforGoods

, where istherealinterestrate.

Investmentisanegative functionoftheinterest rate.

Realinterestrate:truecost ofthefundsusedtofinanceinvestment

Figure 3A.1:InvestmentFunction

Theinvestmentfunctionslopes downward:whentheinterestrate
rises,fewerinvestmentprojectsareprofitable,andsothequantityof
investmentdemandedfalls.

EquilibriuminGoodsMarket
& : exogenousvariablessetbypolicymakers
,
,thelevelofoutputisfixed byinputs
Forsimplicity,
(orfactorsofproduction).
Equilibriumingoodsmarket:

Therealinterestrate istheonlyvariablenot alreadydetermined
sincetheinterestratemustadjusttoensurethattheaggregate
demandforgoodsequalstheaggregatesupply.

.
Attheequilibriuminterestrate,Z(

TheSupplyandDemandforLoanableFunds
Q:Howdoestheinterestrategettothelevelthatbalancesthesupply
anddemandforgoods?
Toseehowtheinterestratebringsthemarketforloanablefundsinto
equilibrium,rewritenationalincomeidentityas:
where

Forfixedvaluesof , , , and , (national)saving isalsofixed.

Figure 3A.2:Saving,Investment,andtheInterestRate

TheSupplyandDemandforLoanableFunds
Thesavingfunctionisavertical linebecauseinthismodelsaving
doesnot dependontheinterest rate.
Theinterestrateadjuststobringsavingandinvestmentintobalance.
Saving:thesupply ofloanablefunds
Investment:thedemand forloanablefunds
Attheequilibriuminterestrate priceofloanablefunds,
thequantityofloanablefundssupplied=thequantityofloanable
fundsdemanded.

ChangesinSaving:TheEffectofFiscalPolicy
Letsseehowfiscalpolicyaffectstheeconomy.
Whenthegovernmentchangesitsspendingortheleveloftaxes,
itaffectstheaggregatedemandforgoodsandalterssaving,
investment,andtheequilibriuminterestrate.
Anincreaseingovernmentpurchases


becauseoutputisfixed bythefactorsofproduction,disposable
income
isunchanged,soconsumptionisunchanged as
well.

Figure 3A.3:ReductioninSaving

ChangesinSaving:TheEffectofFiscalPolicy
Increaseingovernmentpurchases
0 isnot accompaniedby
anincreaseintaxes
Thegovernmentfinancesadditionalspendingbyborrowing
thatis,byreducingpublic saving
Withprivatesavingunchanged,thisgovernmentborrowing
reduces (national)saving
Thesupplyofloanablefundsshiftsleftward
Theequilibriuminterestraterises
Investmentfalls
Thus,anincreaseingovernmentpurchasescausestheinterestrateto
rise from to andtheinvestmenttofall.

ChangesinSaving:TheEffectofFiscalPolicy
Adecreaseintaxes
Areductionintaxesof
0
Disposableincomerises by andconsumptionrisesby

Savingfalls bythesameamountasconsumptionrises,sinceY is
fixedandGremainsunchanged
Thesupplyofloanablefundsshiftstotheleft
Theequilibriuminterestraterises
Investmentfalls
Thus,areductionintaxesraises theinterestrateandcrowds out
investment.

ChangesinSaving:TheEffectofFiscalPolicy
Crowdingout
Thereduction ininvestmentthatresultswhenexpansionaryfiscal
policyraises theinterestrate

ChangesinInvestmentDemand
Wecanalsousethemodeltoinvestigatetheothersideofthemarket
thedemandforinvestment.
CausesofChangesinInvestment:
(i)Technologicalinnovation
(ii)Thegovernmentencouragesordiscouragesinvestmentthrough
thetaxlawssuchasinvestment tax credits.

ChangesinInvestmentDemand
Atanygiveninterestrate,thedemandforinvestmentgoods(andalso
forloanablefunds)ishigher
Theinvestmentfunctionshiftstotheright
Theequilibriuminterestraterises,buttheamountofinvestment
remainsunchanged becauseweassumedthatthesupplyofloanable
fundsorsavingisfixed

Figure 3A.4:AnIncreaseinDemandforInvestment

Becausetheamountofsavingisfixed,theincreaseininvestment
demandraises theinterestratewhileleavingtheequilibriumamount
ofinvestmentunchanged.

Modification:
Consumptiondependsontheinterest rate;
consumptionisanegative functionoftheinterestrate,whichmeans
savingisapositive functionoftheinterestrate,sothesaving
schedulewouldbeupward slopingratherthanvertical.

Figure 3A.5:AnIncreaseinInvestmentDemandWhenSaving
DependsontheInterestRate

AnIncreaseinInvestmentDemandWhenSaving
DependsontheInterestRate
Anincreaseininvestmentdemand
Boththeequilibriuminterestrateandtheequilibriumquantityof
investmentrise
Thus,theincrease intheinterestratecauseshouseholdstoconsume
less andsavemore.Thedecreaseinconsumptionfreesfundsfor
investment.

Example (3A.1):GoodsMarketinClassicalModel
Considerthefollowingmodeloftheeconomy(inbillionsof$):
3600 2000
0.10
1200 4000
1200 and
100
a)Byhowmuchdoes changeforeachpercentagepointincreasein
therealinterestrare ?
(Ans.)

4000

Investmentfallsby4000.

Example (3A.1):GoodsMarketinClassicalModel
b)Writeoutthesavingsfunctionforthiseconomy.Byhowmuchdoes
increasewhen increasesbyoneunit?
(Ans.)
3600 2000
0.10
1200

4800 2000
0.9

0.9

Example (3A.1):GoodsMarketinClassicalModel
c)When
6000
,findtherealinterestratethatclearsthe
marketforgoods.
(Ans.)
Equilibriumcondition:
4800 2000
0.9
1200 4000
0.9
6000 6000 .
6000,0.9 6000 6000 6000
When
6000

600

0.1

10%

Example (3A.1):GoodsMarketinClassicalModel
d)Governmentpurchasesriseto1440,holdingothervariablesconstant.
Howdoesthischangethesavingequation?Showthechangegraphically.
Whathappenstothemarketclearingrealinterestrate?
(Ans.)
3600 2000
0.10
1440
WhenG =1440,

5040 2000
0.9 .
Equilibriumcondition:
5040 2000
0.9
1200 4000
0.9
6240 6000
At
6000,0.9 6000 6240 6000
6000

840

0.14.