ECON 204 Government in the Income- Expenditure Model

Adoption of social state by modern states, extend the role of modern government beyond the
provision of law and order. For the government to provide social welfare in the form of public
goods and services, the government must raise revenue through different sources to finance
public expenditure.
Government aggregate taxes include: Personal income tax, company income tax, property
income tax, and profit income tax, value added tax and excise duties. Government aggregate
expenditure also known as government purchases (G). These relates to (1) government purchases
of final goods and services from the firms (2) constructing roads and bridges, (3) purchase of
office equipment etc. Aside from Government expenditure, there what is called Transfer
Payment, where the government transfer cash to households as social security, unemployment
compensation and to firms as subsidy. It should be noted that transfer payment are government
expenditures that do not represent purchase of final goods or services and they are not related to
current production so they are not included in G and therefore not included in GDP.
Net tax = tax paid to government – transfer payments – interest payments on government
debt.
Demand-side effects of government spending: government purchases directed toward the
domestic private sector (example: buying supplies and labor to build roads). This stimulates
demand in some industries and raises production (GDP). Some economists advocate demand-
side spending policies to help the economy recover from a recession.
Supply-side effects of government spending: The supply side of the economy represents the
capacity of businesses to produce, or “supply,” output. (Whether the businesses actually use the
available capacity may depend on demand.) Some government spending affects productive
capacity of the economy. One example is infrastructure improvements such as highways and
airports that improve the transportation network and raise productive capacity. Perhaps a more
important example is spending on education. An educated work force is more productive than an
uneducated one, which raises the capacity of the economy to produce output. These effects may
be very important, but they can take a long time to have an impact. Thus, the supply-side effects
of government spending are usually not emphasized in discussions of policies to improve the
economy over a short horizon.
Demand side economics: taxes and consumer spending. If the government cuts taxes,
disposable income rises, allowing people to buy more, thus increasing consumption. Policy
makers often propose tax cuts of this kind when the economy is weak.
 Demand-side tax cuts tend to stimulate consumption for the poor or middle class citizens.
Increasing their disposable income will lead to increased spending.
 Increasing the disposable income of the rich may not increase consumption very much.
 Supply side economics: taxes and incentives. The theory behind supply-side tax cuts is
to cut taxes to improve the incentives to work, invest in new factories and equipment, and
develop new products.
- Examples of how this works:
 - If for every hour I work at my job, I get to take home more money, my incentive
to work has increased, so I may work more.
- If a firm has to pay less tax, it will have a greater incentive to invest in new
equipment and new technologies.
The amount that the government collects in taxes does not need to equal the amount that it pays
out for government purchases and transfers. If the government spends more than its revenue, it is
called budget deficit. While on the other hand, if government revenue is greater than its spending
it is called budget surplus. In the case of budget deficit, there are at least two sources of financing
the deficit (1) borrowing from the bond market or (2) printing more money.
The bond market broadly describes a marketplace where investors buy debt securities that
are brought to the market by either governmental entities or corporations.
Decision on debt financing is a tricky dilemma for the government. Most economists agree that
low, even zero, deficits in the long term are a good thing. But deficits may play an important
role in stabilizing weak economies in the short run.
Against deficit financing
The major argument against deficit financing is that future generations of taxpayers will have to
pay the interest and principal created by today's deficits.
-We will explore this claim in detail later in ECON 417. Another argument against deficit
financing is the issue of Interest Rates, When the federal government borrows large amounts in
capital markets, the demand for loans rises. Higher demand for loans can increase interest rates.
-Higher interest rates raise the cost of borrowing for both households and firms.
-If firms and households borrow less due to the higher costs, they will reduce their spending and
businesses will lower production when sales fall. The result is a weaker economy.
-In addition, over a longer horizon, high interest rates may reduce the investment of businesses in
new factories, equipment, and technology. Thus, deficits over the long term that raise interest
rates can reduce the productive capacity of the economy (most important argument).
Argument for deficit financing
The strongest argument for deficit financing is that it stimulate the economy during a recession.
Tax cut and high government spending can do the trick by raising sales and encouraging firms to
produce more and hire more workers. Note that, in the short run deficit must be tolerated and
hopefully in the long run growth will improve, incomes will expand, unemployment will fall,
and tax revenues will grow, reducing the deficit.
The second option is monetizing the debt: The central bank normally subscribe excess bonds, in
the case of over issued .It leads to an increase in monetary base and in the money supply.
Financing a persistent deficit by money creation will lead to a sustained inflation. An critical
element in this process is that the deficit is persistent. If temporary, it would not procedure an
inflation. The one-shot increase in the money supply from the temporary deficit generates only a
one-shot increase in the price level, and no inflation develops.