ECO0006

Economics for Managers

© 2022 Singapore Institute of Management Group Limited

 Lecture 10
Role of Government

Ref:
Tan Khay Boon, Economics for Managers Module Book,
SIM Global Education, 2014
Session 10
Learning Objectives
1. Explain the aims and tools of fiscal policy.
2. Calculate and apply the (government) spending
multiplier and the tax multiplier.
3. Analyze the effects of changes in government
spending and taxes on the economy.
4. Explain the limitations of fiscal policy, the problems
of budget deficit and crowding out effect.
5. Analyze the balanced budget multiplier and role of
automatic stabilizers.

3
 Fiscal Policy
Include:
• the collection of taxes and the payment of
transfer payments such as welfare benefits or
unemployment benefits – into a category we will
call net taxes (T).
– T = tax paid by households and firms minus
transfer payments made to households by the
government.
• government purchases of goods and services or
government expenditure (G).
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 Fiscal Policy
Aims:
• Close severe output gap – difference between
actual output and potential output.

• Smoothen fluctuation in business cycle for

more sustainable real GDP movement.

5
 Output Gap
Actual output: Price

• Short-run equilibrium
output of the economy AS1

• Dependent on the E1

amount of resources P1

utilised in production
AD
• Not all resources may
be utilised
Y1 Real GDP

6
 Output Gap
Potential Output:
• All resources all fully utilised Price
LRAS
in a sustainable way
• Can be produced on a long
term basis
• Output is fixed regardless of
price
• Only changes technology and
quantity/quality of resources
can shift the potential output
• Long run aggregate supply Y* Real GDP
curve 7
 Output Gap
• Actual output < Potential
Price
output
• Difference is known as the
AS1
output gap
• Or recessionary gap E1

P1
• Or contractionary gap
• Occurs due to low AD AD

• To avoid a recession,
government needs to
stimulate AD through Y1 Y* Real GDP
spending
8
 Expansionary Gap
Price
• Actual output > potential
output
AS1
• Demand for output is
greater than what E1
available resources can P1
produce
AD
• Causes inflation as price
for output is bidded up

Y* Y1 Real GDP

9
 Expansionary Gap
Price
• To avoid high level of
inflation, the
AS1
government will attempt
to bring demand or
E1
spending down P1
• Contractionary fiscal P2
E2
policy AD1

• May result in a recession

AD2

Y* Y1 Real GDP
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 Fiscal Policy at Work:
The Multiplier Effect
• The government uses its fiscal policy to change the
equilibrium level of output as well as the unemployment
rate and the inflation rate.

• Changes in government spending and taxes have a

multiplier effect on output and income.

• An increase in government spending has exactly the

same impact on the equilibrium level of output and
income as an increase in planned investment.

• A dollar of extra spending from either G or I is identical

with respect to its impact on equilibrium output.
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 Government Spending Multiplier
• The formula for the government spending
multiplier is the same as the formula for the
expenditure multiplier.

• The government spending multiplier (GSM)

= Change in equilibrium Y_____
Change in government spending
= 1 OR 1__
1-MPC MPS
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 Numerical Illustration
Assume MPC =0.8.
Calculate the change in equilibrium output when
government spending increases by $10m.

THE MULTIPLIER APPROACH

The GSM = 1/ MPS = 1/ 0.2 = 5
Increase in G = $10m,
Increase in equilibrium Y = $10m x 5 = $50m

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 Numerical Illustration
Assume MPC =0.8.
Calculate the change in equilibrium output when
government spending decreases by $20m.

THE MULTIPLIER APPROACH

The GSM = 1/ MPS = 1/ 0.2 = 5
Decrease in G = $20m,
Decrease in equilibrium Y = $20m x 5
= $100m
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 Graphical Illustration
Aggregate Expenditure

C + I + G’

Increase in G by $10m
C+I+G

Output/Income

Increase in Y by $50m
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 Tax Multiplier
• The Tax multiplier  government spending multiplier
• Change in G has a direct effect while change in taxes is
more indirect.
• A $1 increase in G will result in a $1 increase in
spending.
• A $1 decrease in T will result in less than a $1 of
spending, depending on the MPC.
• Because the initial increase in planned AE is smaller for
a tax cut than it is for a government spending increase,
its final effect on the equilibrium level of output and
income will be smaller
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 Tax Multiplier
Tax multiplier (TM) = Change in equilibrium Y
Change in taxes

OR - MPC OR 1– 1__
MPS MPS

The tax multiplier is a negative number

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 Numerical Illustration
Assume MPC = 0.8.
Calculate the change in equilibrium output when
government cuts lump sum net taxes by $10m.

THE TAX MULTIPLIER APPROACH

The TM = -MPC / MPS = -0.8 / 0.2 = -4
Decrease in T = -$10m,
Increase in equilibrium Y = -$10m x -4
= $40m
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 Numerical Illustration
Assume MPC = 0.8.
Calculate the change in equilibrium output when
government raises lump sum net taxes by $20m.

THE TAX MULTIPLIER APPROACH

The TM = -MPC / MPS = -0.8 / 0.2 = -4
Rise in T = $20m,
Decrease in equilibrium Y = $20m x -4
= -$80m
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 Graphical Illustration
Aggregate Expenditure

C’ + I + G
Decrease in T by $10m
(tax rebate)
C+I+G

Output/Income

Increase in Y by 150

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 The Government Budget
Three types of government budget
• Balanced Budget where G = T
• Budget Deficit where G > T
• Budget Surplus where G < T

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 Budget Deficit
• Total revenue < Total Government Spending
• Crowding out effect (private spending)
• Three methods to solve budget deficit
– Reduce government spending (Unpopular)
– Increase taxes (Recessionary & unpopular)
– Borrow (Debt must be returned)

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 Budget Surplus
• Total revenue > Total Government Spending
• Taxes are higher than necessary
• Potentially recessionary
• Provides funds for future spending and the
government does not compete with private
sector for funds to spend

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 Balanced Budget
• Total Spending = Total Government Spending
• Not always better than a budget deficit or a
budget surplus
• Small budget deficit allows scope for building
infrastructure for long term benefit
• A small budget surplus provides funds for
emergency situations

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 Limitations of Fiscal Policy
Discretionary fiscal policy: problems of timing and
time lags
– various time lags (recognition lag,
implementation lag, result lag)
– The intention is to progress from path a to path
b in a typical business cycle but the outcome
that is hampered by lags could be path c.
– policy may be destabilising
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 Limitations of Fiscal Policy
• Recognition Lag
– Time is needed for the problem to surface
and be recognised as such
– Recession is two quarters of decline in real
GDP and inflation requires upward climb in
price index for sustained period
– When the problem is diagnosed, it has
already been happening for a while

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 Limitations of Fiscal Policy
• Decision Lag
– Government needs to decide if it should
change spending patterns, tax structure or
transfer payments
– Legislators must agree on the action to be
taken
– Information gaps on potential output and
size of multiplier
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 Limitations of Fiscal Policy
• Implementation Lag
– Time taken to implement decision
– Invite tenders for government projects,
inform public
– Suppliers need time to react

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 Limitations of Fiscal Policy
• Effectiveness Lag
– Time taken for policy to influence real GDP and
price level
– Consumption pattern takes time to change
– Multiplier effect is not as direct as the formula
suggests
– By the time fiscal policy takes place, the economy
may be in a different situation and the policy
becomes destablising
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Fiscal Policy: Stabilising Or Destabilising?
Path (a): no intervention
Path (b): policy stabilises
3
Real national income

4
3
2
4

2 1

1
Path (c): policy destabilises

O
Time 30
 Crowding Out Effect
• Expansionary fiscal policy combined with a
budget deficit will mean government needs
extra funds
• It can borrow instead of increasing taxes
• This means competition with private
investment for funds
• Increase in G result in a decrease in I and a
rise in interest rate
• Future grow of economy may be affected
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 Crowding Out Effect
Price

E2 AS1
P2
E3
P3

P1 E1
AD2 (G increases)

AD1
AD3 (I decreases)
Y1 Y3 Y2 Real GDP
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 Balanced Budget Multiplier
• Government funds increased spending by raising
taxes by the same amount
• Ratio of the change in the equilibrium level of
output to a change in government spending and
a change in taxes where the change in G and the
change in T must be in the same direction as
well as of the same amount
• BBM = 1

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 Balanced Budget Multiplier

Y = 1 G + - MPC T
1 - MPC 1 - MPC
= 1- MPC G
1 - MPC
= 1 – MPC T
1 - MPC
= G
= T
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 Balanced Budget Multiplier
If G increases by $100m and this is financed by a
$100m increase in T (i.e. G = +100 and T = +100)

• If MPC = 0.75, C will fall by $75m because of the

tax rises.
• Net effect on AE will be -$75m +$100m = $25m
• Expenditure Multiplier = 1/0.25 = 4
• Output will therefore increase by $25m x 4
= $100m
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 Reality Check
• The multiplier concept is still incomplete and
oversimplified. The multiplier effect is in reality
smaller.
• In reality, it is not so easy to raise government
spending.
• We have assumed that prices remain unaffected.
In reality, prices will rise as the economy expands
and this will reduce spending and reduce the size
of the multiplier

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 Summary
Investment Multiplier 1__
MPS
Government Spending Multiplier __1__
(GSM) MPS

Tax Multiplier (TM) -MPC

MPS

Balanced Budget Multiplier (BBM) 1

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 FISCAL POLICY
Automatic fiscal stabilisers: G or T that takes place without
any deliberate fiscal policy decisions. They automatically
expand during recessions and contract during boom
period.
– Progressive income tax: in a recession, wages fall and
tax revenues fall. Households move into lower tax
brackets. Dampen the fall in after-tax income.
– Unemployment benefits: Increased welfare payments
and unemployment benefits in a recession limit the
decline of C by replacing some of the incomes lost.
Removed once employment is regained.
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 Discussion Question 1
The AD curve ______ because, holding all else
constant, an increase in ______ causes consumption,
investment and net export to fall.

A. slopes downward; real GDP

B. slopes downward; the price level rate
C. slopes upward; real GDP
D. is horizontal; the price level rate

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 Discussion Question 2
When government outlays exceed tax receipts, this is
called _____________.

A. a debt
B. the crowding out effect
C. a budget deficit
D. an expansionary fiscal policy

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 Discussion Question 3
When actual output = potential output and the price
level is at its equilibrium level, the economy is said to
be in ________ .

A. long run equilibrium

B. a contractionary gap
C. in an expansionary gap
D. short run equilibrium

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 Discussion Question 4
The economy is in long run equilibrium ____________.

A. when the AD and AS curves intersect at potential

output Y*.
B. when the AD and AS curves intersect to the right of
Y*.
C. when the AD and AS curves become vertical.
D. when AD and AS curves intersect to the left of Y*.

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 Discussion Question 5
When the government raises taxes, _____________.

A. the AS curve will shift right.

B. the AS curve will shift left.
C. the AD curve will shift right.
D. the AD curve will shift left.

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 Discussion Question 6
An economy is described by the a. What are the values for the
following equations: expenditure multiplier and the
tax multiplier?
C = 2,000 + 0.75 (Y – T) b. If the government expenditure
Ip = 1000 increases by 50, what will be
G = 1,800 the change in equilibrium level
of output?
NX = 100
T = 1,800 c. If taxes decrease by 50, what
will be the change in
Y* = 15,000
equilibrium level of output?

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 Discussion Question 7
Use an AD-AS diagram to show the short-run
effects on output and inflation when
government increases the government
purchases. Assume the economy starts in long-
run equilibrium.

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Thank you