Fiscal policy government s spending and taxing policies Monetary policy behavior of Federal Reserve co Corning nation s money supply Government in the Economy Distinguish between variables that government controls directly and variables that are a consequence of government decisions combined with the state of the economy Example tax rates are controlled by government congress has the authority to decide who and what should be taxed and at what rate Tax revenue is not subject to complete control by government Revenue from personal income tax system depends on personal tax rates which congress sets and on the income of the household sector gov t does not control Discretionary scal policy changes in taxes or spending that are the result of deliberate changes in government policy Government Purchases G Net Taxes T and Disposable Income Yd Net taxes T taxes paid by rms and households to the government minus transfer payments made to households by government Disposable or after tax income Yd income that ultimately gets to households total income minus net taxes Y T Excludes taxes paid by households and includes transfer payments made to households by government Taxes that do not depend on income are sometimes called lump sum taxes Yd C S Y T C S Y C S T AE C I G Budget de cit difference between what government spends and what it collects in taxes in a given period G T If G exceeds T the government must borrow from the public to nance the de citby selling Treasury bonds and bills A part of household saving S goes to the government If G is less than T which means government is spending lessis collecting in taxes the government is running a surplus Budget surplus is simply a negative budget de cit Adding Taxes to the Consumption Function C a bY modify to incorporate disposable income instead of before tax income C a b Yd or C a b Y T The Determination of Equilibrium Output Income Y C I G If output Y exceeds planned aggregate expenditure C I G there will be unplanned increase in inventories actual investment will exceed planned investment If C I G exceeds Y there will be unplanned decrease in inventories Example consumption function C 100 75Yd or C 100 75 Y T Assume G is 100 and T is 100 gov is running balanced budget Assume planned investment I is 100 At Y 500 disposable income is Y T or 400 Therefore C 100 75 400 400 Assuming I is 100 and G is 100 planned aggregate expenditure is 600 C I G 400 100 100 Because output Y is only 500 planned spending is greater than output by 100 There is an unplanned inventory decrease of 100 giving rms an incentive to raise output Thus output of 500 is below equilibrium At Y 1 300 then Yd 1 200 Here planned spending is less that output there will be unplanned inventory increase of 100 and rms have an incentive to cut back output Only when output is 900 and planned aggregate expenditure equal and only at Y 900 does equilibrium exist Thus output of 1 300 is above equilibrium The Saving Investment Approach to Equilibrium Government takes out net taxes T from the ow of income a leakage and households save S some of their income also leakage from the ow of income If leakages S T equal planned injections I G there is equilibrium S T I G Equilibrium does not require G T balanced gov budget or that S I Fiscal Policy at Work Multiplier Effects The Government Spending Multiplier Example unemployment is too high and you need to lower unemployment by increasing input and outcome determine acceptable unemployment rate can be reached only if aggregate output increases to 1 100 Now need to determine how gov can use scal policy to increase equilibrium level of national output suppose taxes must remain at present levels Only option is to increase government spending G while holding taxes constant To increase spending without raising taxes gov must borrow When G is is bigger than T the gov runs a de cit and the difference between G and T must be borrowed How much of an increase in spending would be required to generate increase of 200 in equilibrium level of output pushing it from 900 to 1 100 and reducing unemployment to acceptable level Use government spending multiplier 1 MPS ratio of the change in the equilibrium level of output to a change in government spending Increase gov spending G by 200 Use multiplier to see what new equilibrium level of Y would be for an increase in G of 200 Multiplier is 4 because b the MPC is 75 the MPS must be 1 75 25 and 1 25 4 Thus Y will increase by 800 4x200 Because initial level of Y was 900 new equilibrium level of Y is 900 800 1 700 when G is increased by 200 Level of 1 700 is much larger than the level of 1 100 we calculated as being necessary to lower unemployment rate to desired level If we want to increase Y byb200 and the multiplier is 4 we need G to increase by only 200 4 50 If G changes by 50 the equilibrium level of Y will change by 200 and the new value of Y will be 1 100 900 200 as desired The Tax Multiplier Example devise plan to reduce unemployment to acceptable level without increasing level of government spending You decide to cut taxes and maintain current level of spending tax cut increases disposable income which is likely to lead to added consumption spending Would decrease in taxes affect aggregate output income the same as an increase in G Decrease in taxes would increase income Gov spends no less than it did before tax cut and households nd that they have larger after tax disposable income than they had before This leads to increase in consumption Planned aggregate expenditure will increase which leads to inventories being lower than planned which will lead to rise in output When output rises more workers will be employed and more income will be generated causing second round increase in consumption and so on Tax multiplier ratio of change in equilibrium level of output to a change in taxes MPC MPS Because a tax cut will increase consumption expenditures and output and a tax increase will cause reduction in consumption expenditures and output tax multiplier is negative The MPC is 75 so the multiplier is 75 25 3 A tax cut of 100 will increase equilibrium level of output by 100 x 3 300 The Balanced Budget Multiplier What if gov spending and taxes are increased by same amount That is what if the gov decides to pay for its extra spending by increasing taxes by same amt Government s budget de cit would not change because increase in expenditures would be matched by increase in tax income Balanced budget increase in G
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