FISCAL POLICY

Goodwin, Neva, Jonathan Harris, Julie Nelson, Brian

Dr. Manika Bora
Roach and Mariano Torras. “Macroeconomics in
Context”, Chapter 25
 FISCAL POLICY
Government spending and tax policy
What does government spend?
How it gets the money it spends?
Effects on the GDP?
Include the government in model
AD = C + II + G
Let us take each component of this equation, G, C, I I
 GOVERNMENT SPENDING
The component of GDP that represents spending on goods and services
by central, state and local governments
Much of government spending (excluding transfers) is on general public
services, health, and education. Government spending does not change in
a systematic way with changes in income.
An increase in government spending shifts the aggregate demand
The economy is at unemployment equilibrium
Let us add an exogenous government spending variable, G
= 80
New equilibrium at Y = 800
GOVERNMENT SPENDING Multiplier effects

New equilibrium at full-

employment level at 800
So, how much expenditure
does the government need to
undertake to increase output
by 400?
 SHIFT IN AGGREGATE DEMAND
BECAUSE OF GOVERNMENT
SPENDING
An increase in government spending has a similar effect to an increase in private
fixed investment.
It shifts the AD line upward, as government spending rises. This increases the
equilibrium levels of income and output.
 The increase in Y is larger than that of G because of the multiplier effect, which
occurs due to the induced consumption that occurs as the economy expands
along the AD line.
Suppose that government spending were reduced from 80 to 60
= - 20
Mult = 5
=?
So, increase in G is leading to increase in Y
And decrease in G is leading to fall in Y
 TAXES AND TRANSFER PAYMENTS

Transfer payments – payments by government to individuals or

firms, in the form of grants, subsidies and gifts. Eg.
unemployment insurance
G directly affects AD , while taxes and transfer payments have
indirect effects
TAXES AND TRANSFER PAYMENTS

Disposable income – income remaining for consumption or

saving after subtracting taxes and adding transfer payments

Tax cut = –50

MPC = 0.8, increase in consumption?
Transfer payment = 50, effect on AD?
 TAX MULTIPLIER
Lump sum taxes:
Tax multiplier – impact of a change in a lump sum tax on economic
equilibrium,
Tax multiplier works in two stages.
Stage 1: Consumption is reduced

Stage 2: Multiplier effect on equilibrium income

TAX MULTIPLIER
Mathematically, tax multiplier turns out to be lower than the
regular multiplier

If, MPC = 0.8, Mult = 5,

tax multiplier = - Mult. Mpc
= - 0.8 x 5 = –4
If tax increase has a contractionary effect on income, tax cuts will
have an expansionary effect
TAX MULTIPLIER WITH TRANSFER PAYMENT

Similar effect of Transfers (sort of like negative tax)

 Increase in TR, gives people more money to spend.
 But they do not spend all, so TR affects AD depending on how
much people save.
Expansionary effect of TR through same multiplier effect but
in the opposite direction.
 Decline in TR will have contractionary effect , meaning lower
equilibrium exactly like tax increase
 WHAT ABOUT PROPORTIONAL
TAXATION?
Household consumption spending depends on post-tax income. The government charges a tax
t, which we assume is proportional to income.
The income left after the payment of tax, (1 − t)Y, is called disposable income.
The marginal propensity to consume, c1, is the fraction of disposable income (not pre-tax
income) consumed.
Proportional or progressive taxes – increase with income levels
Proportional tax – T = t.Y
Flatter AD curve – reduces multiplier
15% tax – each rupee of income will be reduced to 0.85 of disposable income
0.68 (0.8 * 0.85) to consumption and 0.17 to saving
Lower MPC – lower multiplier
TAX MULTIPLIER

Balanced budget multiplier – the impact on equilibrium

output of simultaneous increases of equal size in
government spending and taxes
Net positive effect on AD and equilibrium
Net multiplier effect equals 1
G multiplier = 5, Tax multiplier = –4, BB multiplier = 1
 TAX MULTIPLIER

Increase of Rs. 50 billion in government spending

Equal increase of Rs. 50 billion in taxes
Net increase in equilibrium output of Rs. 50 billion
if increase in only government spending by Rs. 50 billion?
CIRCULAR FLOW WITH GOVERNMENT
SPENDING AND TAXES
Net taxes = Taxes – Transfer
payments
Leakages: savings, net taxes
Injections: intended investment,
government spending
Full-employment equilibrium if
overall leakages and injections
balance
 From Keynesian perspective the
objective of the government is to
vary G and NT to offset
imbalance of savings and
investment