Transcript Topic 3: Fiscal Policy

Topic 3: Fiscal Policy
Circular Flow
Keynesian Economics
Taxes and Government Spending
1
Economic Output Equation
Y = GDP = C + I + G + X – M
 Y = National Income
 C = Consumption
 I = Investment
 G = Government Spending
 X – M = Net Exports
2
Focus on National Income
Y=C+I+G+X–M
 In “equilibrium” total national expenditures equal total
national income. Both are measures of “Output”
3
Focus on National Income
Y=C+I+G
 For now, we will also assume that net exports are zero. This is
the case when X = M, or if the economy is closed (i.e., it
doesn’t trade with others)
 We will allow for trade later in the course
4
Let’s go through these one at a time
Y=C+I+G
5
What is consumption?
 The amount people (e.g., households) spend on newly
produced goods and services
 Cars
 Books
 Accountants
 Food
 Clothes
 Beer
 Pets
 Tuition
 Nanny
 Garbage bags
 Everything
6
How much do people consume?
 Depends on people’s income
 C is increasing in “disposable” (after-tax) income
 Represent this using an equation. For example:
C = 100 + 0.9 ( Y – Tx )
(This means that people consume 100, plus 90% of
disposable income)
7
Consumption Equation
 A general form of the equation:
C = Cmin + MPC ( Y – Tx )
 Cmin = spending even when there is no income (must eat to
survive)
 mpc = “Marginal Propensity to Consume”
 Y – Tx = disposable income (Tx is taxes and Y is income)
8
Marginal Propensity to Consume
C = Cmin + MPC ( Y – Tx )
 Income can be spent on consumption, saved, or used to pay
taxes.
 MPC is the portion of disposable income that households spend
on consumption
 1 – MPC is therefore the portion of disposable income
households save. It is called the “marginal propensity to save”
9
Consumption Functions
 If households always spend $750, plus 80% of their disposable
income, then
C = 750 + 0.8 ( Y – Tx )
 If households always spend $1000, plus 75% of their disposable
income, then
C = 1000 + 0.75 ( Y – Tx )
10
What is Investment?
Spending by investors (whom may be businesses, financial
institutions, governments or households) on:
11
What is Investment?
1.
12
Plant & Equipment
What is Investment?
2.
13
New Residential Construction
What is Investment?
3.
14
Inventories
Inventories

Intermediate goods to be used in future production
Final good not yet sold

Inventories are important:

 If people buy too little: companies are overproducing,
inventories will rise, then firms slow down production
 If people buy too much: companies don’t produce enough,
inventories fall, then firms increase production
15
What is Investment?
Spending by investors (whom may be businesses, financial
institutions, governments or households) on:
Plant & Equipment
2. New Residential Construction
3. Inventories
1.
16
Calculating Output
Y=C+I+G
C = Cmin+ MPC ( Y – Tx)
Y = [Cmin+ MPC ( Y – Tx)] + I + G
17
Solving for Equilibrium Y
 Suppose
 C = 100 + 0.75 (Y-Tx)
 I = 1000
 G = Tx = 500 (i.e., there is a balanced budget)
 What is National Income?
 Y = 4900
18
Solving for Equilibrium Y
 Now, consumers become more optimistic about future
income, and in response, they spend an extra 5% of their
disposable income. Therefore, MPC goes from 0.75 to 0.8.
 What is National Income?
 Y = 6000
19
Solving for Equilibrium Y
 Assume again that MPC = 0.8.
 Now the government increases spending by 200 (G increases
to 700) while keeping taxes unchanged at 500.
 What is National Income?
 Y = 7000
 Illustrate this change on the circular flow diagram
20
Solving for Equilibrium Y
 Assume again that MPC = 0.8.
 G = 700
 Now the government cuts taxes by 200 from 500 to 300.
 What is National Income?
 Y = 7800
 Illustrate this change on the circular flow diagram
21
Solving for Equilibrium Y
 Now, MPC = 0.8, G = 700, Tx = 300.
 Investment increases from 1000 to 1200
 What is National Income?
 Y = 8800
 Illustrate this change on the circular flow diagram
22
What have we shown?
 National Income increases when:
 MPC increases
 Government spending increases
 Taxes decrease
 Investment increases
23
Converse is also true
 National Income decreases when:
 MPC decreases
 Government spending decreases
 Taxes increase
 Investment decreases
24
Keynesian Multipliers
 Tell us how much Y changes given a change in I, or G, or Tx
 Technically, they equal to:
Y
I
Y
G
Y
Tx
(But, you if you are not comfortable with calculus, don’t worry
 about these
 expressions)

25
Calculating Keynesian Multipliers
Y  Cmin  MPC(Y  Tx)  I  G
Y Y  MPC  Cmin  MPC  Tx  I  G

Y(1 MPC)  Cmin  MPC  Tx  I  G

Y 
26
1
MPC
1
1
Cmin 
Tx 
I
G
(1  MPC)
(1  MPC)
(1  MPC)
(1  MPC)
Keynesian Multipliers
 For Investment
1
1  MPC
 For Government Spending
1
1  MPC

 For Taxes

27
MPC

1  MPC
Keynesian Multipliers
1
Y  I
1  MPC


28
1
Y  G
1  MPC
MPC
Y  Tx
1  MPC
Example
 If the MPC is 0.8, and G increases by 200:
1
1
1 10



5
1  MPC 1  0.8 0.2 2

 Then Y increases by:
1
Y  G
 200  5  1000
1  MPC
29
Example
 If the MPC is 0.8, and Tx decreases by 200:
MPC
0.8
0.8
8


   4
1  MPC
1  0.8
0.2
2
 Then Y increases by:

MPC
Y  Tx
 200  (4)  800
1  MPC
30
Using Fiscal Policy
 Fiscal policy: government’s attempt to influence national
income by adjusting government spending and taxation
 G and Tx are determined by government (congress)
 Fiscal policy provides tools for the government to “slow
down” or “speed up” the economy
31
Using Expansionary Fiscal Policy
Expansionary Fiscal Policy
 Policy designed to “speed up” the economy, encourage more
output
 Increasing G
 Decreasing Tx
 Expansionary policy increases Y
 If there are unemployed/underutilized resources in the
economy, then these resources can be used to increase
production… unemployment decreases
 If the economy is near full employment, then there is no
unemployment to decrease… get inflation
32
Using Contractionary Fiscal Policy
Contractionary Fiscal Policy
 Policy designed to “slow down” the economy
 Decreasing G
 Increasing Tx
 Contractionary policy decreases Y
 Slowing down the economy can decrease inflation
 But, it also will increase the unemployment
33
Full Employment Level of Income
 At the “full employment” level of national income, the
economy is at full employment, and there isn’t too much
inflation
 If national income exceeds the full employment level, there is
too much inflation
 If national income is below the full employment level, there
is too much unemployment
34
Fiscal Policy Example 1
 Suppose
 C = 100 + 0.75 (Y-Tx)
 I = 400
 G = Tx = 200
 What is National Income?
 Y = 2200
35
Fiscal Policy Example 1
 If the full employment level of National Income is
2600, then is expansionary or contractionary
policy appropriate?
 If the government wants to achieve the full
employment level by increasing government
spending, then by how much must G increase?
36
Fiscal Policy Example 1
 If the government wants to achieve the full
employment level of 2600 by decreasing taxes,
then by how much must Tx decrease?
 If the government cuts taxes by more than this
amount, then what happens to inflation?
37
Fiscal Policy Example 2
 Suppose
 C = 200 + 0.5 (Y-Tx)
 I = 500
 G = Tx = 300
 What is National Income?
 Y = 1700
38
Fiscal Policy Example 2
 If the economy is currently experiences high
inflation and low unemployment, then is
expansionary or contractionary policy
appropriate?
 The government wants to use fiscal policy to
achieve the full employment income of 1500
without changing taxes. What should it do?
39
Fiscal Policy Example 2
 The government wants to use fiscal policy to
achieve the full employment income of 1500
without changing government spending. What
should it do?
 The government wants to use fiscal policy to
achieve the full employment income of 1500
while maintaining a balanced budget. What
should it do?
40