UGBS 204:Macroeconomics for Business

Lecture four

• Fiscal Policy in Simple Keynesian System

LECTURER: 1
May 21, 2024
 FISCAL POLICY
• Fiscal Policy

– Meaning of Fiscal Policy

– Fiscal Policy As Stabilization Tool

– Other Issues Related to Fiscal Policy

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 What is Fiscal Policy?

• Fiscal policy refers to changes in the level of government spending and/or

taxes meant to influence the level of economic activity

• Reading of the budget statement is announcement of gov’t fiscal policy

• Fiscal policy may be expansionary or contractionary

• Expansionary policy: also fiscal loosening refers to increases in

govt spending or reduction taxes

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 Types of Fiscal Policy

• Fiscal policy may be expansionary or contractionary

• Expansionary policy: (fiscal loosening) refers to increases in

govt spending and/or reduction taxes

• Contractionary policy: (fiscal tightening) refers to increases in

govt taxes and/or reduction in govt spending
– fiscal austerity

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 Fiscal Policy in the Simple Keynesian
System

• Recall from last week: basic relationships in this economy are:

– C=a+b
– I=
– G=
– T=
• The equilibrium condition requires that Y=AD
• That is:
– Y=AD=a+b(Y-T)+
– Y-bY=a+ =>Y( 1-b )=a-b ++

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 Autonomous Spending multiplier

• Recall from last week: is called the autonomous expenditure multiplier

• It is a multiple by which a change in any component of autonomous

expenditures increases equilibrium output

• In this simplified framework, the components of autonomous spending are

– a, ,

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 Autonomous Spending multiplier

• From the previous example, what is the effect on an increase in taxes () on

equilibrium income

• If we differentiate with respect to we have:

=

• This is the autonomous tax multiplier that shows the effect of

changes in autonomous taxes on equilibrium
– the negative shows that an increase in tax will reduce equilibrium income

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 Balanced-budget Multiplier (1)

• What will the multiplier be if government increased its Spending by raising

an equal amount in autonomous tax?

• The balanced-budget multiplier shows the effect on income of an increase

in government spending and autonomous taxes by equal amounts

• The balanced budget multiplier is 1, this means that equilibrium income

will increase by the same amount of the increase in government spending
and taxes

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 Balanced-budget Multiplier(2)

• To see this, note that if G increases by △G, the overall effect on Y will be
△G*

• If T increases by △T the effect on Y will be △T*

• Note that since taxes and spending increase by the same amount, △G= △T
• Add the two effects up gives:
– △G*-△G* = △G() = △G

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 Example (1)
– Consider the following:
– C=100+0.8
– I=200
– G=80
– T=70

• In this example, the marginal propensity to consume is 0.8

• 80% of any additional income goes to consumption

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 Example (2)
• In this example, the autonomous spending multiplier is:
– = =5
– If any component of autonomous spending increase by 1 unit,
output will increase by 5 units
• The autonomous tax multiplier is
– = =-4

• An increase in autonomous taxes by 1 unit will decrease equilibrium

income by 4 units

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 Example (3)

• We can now solve for the equilibrium

• In equilibrium Y=AD
– Y = 100+0:8( Y -70)+200+80
– Y = 324+0:8 Y
– 0.2 Y = 324
– Y=1620

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 Actual GDP, Potential GDP and Output
Gap
• Actual GDP (Y* ) refers to what the economy does produce, whilst Potential
GDP (Yp) refers to what the economy could produce if all the resources in the
economy are fully utilized

• The difference between what the economy could have produced and what
actually is produced is referred to as the Output (GDP) Gap

• Output gap = Yp –Y*

– If output gap is positive ie Yp > Y* we have recessionary gap

– If output gap is negative ie Yp < Y* we have inflation gap
– If output gap is zero ie Yp = Y* we have full employment

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 Recessionary Gap

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 Inflationary Gap

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 Fiscal Policy as Stabilization Tool

• A major goal of fiscal policy is to stabilize actual output close to the potential
output

• If actual output is greater than potential output (inflationary gap),

contractionary fiscal policy can be used reduce output to the potential output

• If actual output is less than potential output (recessionary gap), expansionary

fiscal policy can used to increase output to the full employment output.

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 Fiscal Policy as Stabilization Tool

• Consider our previous example:

– C=100+0.8
– I=200
– G=80
– T=70
• We saw that the equilibrium income or actual output 1620

• Suppose the potential output is 2000

– in this example we have a recessionary gap

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 Fiscal Policy as Stabilization Tool

• The government can use an expansionary fiscal policy to remove this gap

• Since the output gap is 380=2000-1620 and the autonomous spending

multiplier is 5 government does not have to increase spending by 380

• Government can increase spending by only 76

• △G = =76

• If government alternatively chose to reduce taxes, by how much should taxes

be reduced?

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 Automatic Stabilizes

• Automatic stabilizers refer to in-built fiscal mechanisms within an economy that

dampens effects of fluctuations in aggregate demand on actual output

• They ensure that during recessions, when loss of jobs lead to loss of incomes,
consumption expenditures do not fall so much to deepen the recession

• Examples include unemployment insurance/compensation

• Automatic stabilizers are more prominent in developed countries than in developing

countries

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 Automatic Stabilizes

• Automatic stabilizers refer to in-built fiscal mechanisms within an economy

that dampens effects of fluctuations in aggregate demand on actual output

• They ensure that during recessions, when loss of jobs lead to loss of incomes,
consumption expenditures do not fall so much to deepen the recession

• Examples include unemployment insurance/compensation

• Automatic stabilizers are more prominent in developed countries than in

developing countries

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 Crowding-out Effect

• Expansionary fiscal policy stimulates aggregate demand for

• goods and services but also raises interest rates
– Governments borrows when it runs expansionary fiscal policy
– The additional borrowing raises interest rate

• Higher interest rate increases the cost of investment, reducing Investment

– Higher interest rates may also reduce private consumption

• Crowding-out refers offset in aggregate demand that results when

expansionary fiscal policy raises the interest rate and thereby reduce
investment spending

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