1 FINA 353 Principles of Macroeconomics Lecture 9 Topic: Fiscal Policy FINA 353 Principles of Macroeconomics Lecture 9 Topic: Fiscal Policy Dr. Mazharul Islam

What is Government BUDGET? The government budget is an annual statement of the revenues, outlays, and surplus or deficit of the government. 7/11/2016Dr. Mazharul Islam2

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. 7/11/2016Dr. Mazharul Islam3

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 Multiplier Effect of the Fiscal Policy

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. 7/11/2016Dr. Mazharul Islam5 The government expenditure multiplier shows the effect of a change in government expenditure on goods and services on aggregate demand

The Tax Multiplier  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. 7/11/2016Dr. Mazharul Islam6 The tax multiplier shows the effect of a change in taxes on aggregate demand.

The Tax Multiplier 1  Simple Tax Multiplier = - MPC X MPS 1 = - MPC X (1-MPC) 7/11/2016Dr. Mazharul Islam7

The Transfer Payments Multiplier  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). 7/11/2016Dr. Mazharul Islam8 The transfer payments multiplier shows the effect of a change in the transfer payments on aggregate demand.

The Balance Budget Multiplier  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. Definition: the effect on aggregate demand of a simultaneous change in government expenditure and taxes that leaves the budget balance unchanged.

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. 7/11/2016Dr. Mazharul Islam10

Fiscal Stimulus: When Real GDP is low: 7/11/2016Dr. Mazharul Islam11

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. 7/11/2016Dr. Mazharul Islam12

Fiscal Stimulus: When Real GDP is low 7/11/2016Dr. Mazharul Islam13

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. 7/11/2016Dr. Mazharul Islam14

Contractionary Fiscal Policy: Above Full Employment 7/11/2016Dr. Mazharul Islam15

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. 7/11/2016Dr. Mazharul Islam16

Contractionary Fiscal Policy: Above Full Employment 7/11/2016Dr. Mazharul Islam17

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 full- employment 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.