Transcript Chapter 16: FISCAL POLICY

FISCAL POLICY
Chapter 16
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Dr. Mazharul Islam
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What is Government BUDGET?

The government budget is an annual
statement of the revenues, outlays, and
surplus or deficit of the government.
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What is FISCAL POLICY?

Fiscal Policy: fiscal policy is the policy
that use by the government for revenue
collection (taxation) and expenditure
(spending)
to
achieve
the
macroeconomic goals namely sustained
economic growth and full employment.
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The Multiplier Effect of the Fiscal
Policy
 Other things remaining the same a
change in any of the items in the
government budget changes aggregate
demand and has a multiplier effect.
 Aggregate Demand changes by a
greater amount than the initial change
in the item in the government budget
The Government Expenditure
Multiplier
 Government expenditure is a component of
aggregate expenditure, so when government
expenditure increases, aggregate demand increases.
 Then real GDP increases and encourages an
increase in consumption expenditure, which brings
a further increase in aggregate expenditure.
The government expenditure multiplier shows
the effect of a change in government expenditure
on goods and services on aggregate demand
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The Tax Multiplier
 The tax multiplier shows the effect of
a change in taxes on aggregate demand.
 A decrease in taxes increases disposable
income, which increases consumption
expenditure.
 The size of tax multiplier is smaller than
the government expenditure multiplier
because “a $1 tax cut generates less than
$1 of additions expenditure.” Tax
multiplier always be negative.
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The Tax Multiplier
1
 Simple Tax Multiplier = - MPC X -------MPS
1
= - MPC X -------(1-MPC)
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The Transfer Payments Multiplier
 The transfer payments multiplier shows the effect of a
change in the transfer payments on aggregate demand.

This multiplier works like the tax multiplier but in the
opposite direction that means it is always positive.
 An increase in transfer payments increases
disposable income, which increases consumption
expenditure.

The size of the transfer payments multiplier is smaller than
the government expenditure multiplier ( it is similar to tax
multiplier).
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The Balance Budget Multiplier
 Definition: the effect on aggregate demand of a
simultaneous change in government expenditure and
taxes that leaves the budget balance unchanged.



The balance budget multiplier is not zero.
It is greater than zero because “a $1 increase in
government expenditure injects a dollar more into the
aggregate demand while a $1 tax rise (or decrease in
transfer payments) takes lass than $1 from aggregate
demand.”
So when both government expenditure and taxes
increase by $1, aggregate demand increases.
A Successful Fiscal Stimulus
(expansionary fiscal policy)
 If real GDP is below potential GDP, the
government might practice a fiscal stimulus
by:
I. Increasing its expenditure on goods &
services
II. Increasing transfer of payments
III. Cutting taxes (reducing taxes)
Or a combination of all three.
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Fiscal Stimulus: When Real GDP is
low:
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Figure 6.1 :Illustration
In the figure , potential GDP is $ 13 trillion but
real GDP is $ 12 trillion.
 The economy is at point {A}
 The red-arrow shows the recessionary gap.
 To eliminate the recessionary gap and restore full
employment,
the
government
increases
expenditure or cuts taxes , to increase aggregate
expenditure by E
This increase is illustrated in figure 6.2 , where full
employment is achieved.

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Fiscal Stimulus: When Real GDP is
low
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A Successful Contractionary Fiscal
Policy
If real GDP is above potential GDP, the government
practices a contractionary fiscal policy.
 Contractionary Fiscal Policy: A decrease in
government expenditure on goods and
services, in transfer of payments, or raise in
taxes to decrease aggregate demand.
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Contractionary Fiscal Policy: Above Full Employment
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Figure 6.3 :Illustration
In the figure , potential GDP is $ 13 trillion but
real GDP is $ 14 trillion.
 The economy is at point {A}
 The yellow- arrow shows the inflation gap.
 To eliminate the inflation gap and restore full
employment, the government decreases
expenditure or rises taxes , to decrease
aggregate expenditure by
E
This decrease is illustrated in figure 6.4 , where
full employment is achieved.

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Contractionary Fiscal Policy: Above Full Employment
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The Supply Side: Potential GDP &
Growth
Fiscal policy can influence the output gap by changing the
aggregate demand and the real GDP relative to the
potential GDP.
But fiscal policy also influences potential GDP and
the growth rate of potential GDP.
These influences rises because the government
provides public goods and services that increase
productivity and because taxes change the
incentives that affect people.
These influences are called SUPPLY-side effects,
operates more slowly than the DEMAND-side
effects.
The Supply Side: Potential GDP &
Growth
In recession: Supply-side effects are ignored as
the focus is on fiscal stimuli and restoring full
employment.
In the long-run: Supply-side effects will dominate
and determine the potential GDP.
First we consider that how, in the absence of
government services and taxes ,the full employment
and potential GDP are determined.
The Supply Side: Full Employment & Potential
GDP
The quantity of labor demanded and supplied
depend on real wage rate.
The higher the wage rate, other things remaining
the same, the smaller is the quantity of labor
demanded and the greater is the quantity of labor
supplied.
When the wage rate is adjusted to equal the
quantity of labor demanded and supplied – there is
full employment.
When it is full employment , the real GDP
is equals potential GDP.
The Supply Side: Full Employment & Potential GDP
With consideration of government services and
taxes:
Both sides of the government budget influence the
potential GDP.
The expenditure side provides the public goods and
services that increases productivity.
This increase in productivity increases the potential GDP.
On the revenue side, taxes modify the incentives and
change the full-employment quantity of labor (i.e. the
equilibrium of demanded and supplied labor), as well as the
amount of saving and investment.
The Supply Side: Public Goods and Productivity
The government provides a legal system and
other infrastructure services – which
increase the nation’s productivity.
Public goods and services financed by
government, increase the real GDP that a
given amount of labor can produce.
This means the provision of public goods
and services increases potential GDP.
The Supply Side:Taxes and Incentives
An increase in taxes drives a wedge between
the price paid by a buyer and the price
received by a seller.
In the labor market income tax drives a
wedge between the cost of labor to
employers and the take-home pay of
workers.
Income tax lowers the incentive to work , save
and invest and decreases the fullemployment quantity of labor. Therefore the
potential GDP becomes lower and the
aggregate supply curve shifts to the left.
The Supply Side:Taxes and Incentives
Taxes on consumption expenditure add to
the tax wedge that lowers the potential GDP.
The reason is that a tax on consumption
expenditure raises the prices paid for
consumption goods and services and is
equivalent to a cut in the real wage rate.
Therefore, the higher the tax on
consumption expenditure, the smaller is the
quantity of goods and services that an hour of
labor can buy and the weaker is the incentive
to the supply labor.