0 Macroeconomics (ECON 1211) Lecturer: Dr B. M Macroeconomics (ECON 1211) Lecturer: Dr B. M. Nowbutsing Topic: Aggregate demand, fiscal policy, and foreign trade
1 Some Key Terms Fiscal policy Stabilization policy Budget deficit the government’s decisions about spending and taxesStabilization policygovernment actions to try to keep output close to its potential levelBudget deficitthe excess of government outlays over government receiptsNational debtthe stock of outstanding government debtSee the introduction to Chapter 22 in the main text.
2 The Government and the Circular Flow Introduction of Government: Another AgentAD = C + I + G (assumed that G is autonomous)YD = Y – NTIf NT = tY (0<t<1); YD = Y (1- t)C = f (YD), slope of consumption function is lower with taxes.If autonomous consumption is zero and MPC = 0.8.Then C = 0.8 YD = 0.8 (1 – t) YIf tax rate = 0.2, then C = 0.64 YThis implies MPCT = MPC (1 – t)
3 3. Government in the Income-Expenditure Model Direct taxesaffect the slope of the consumption functionand hence the slope of the AD schedule.Government expenditure affects the position of the AD schedule
4 4. A Higher Net Tax Rate AD0 AD1 Y1 Y0 An increase in tax rate shift the consumption functionwhich in turn shift the ADcurveAggregate demandAD0Income,output45o lineY1AD1Y0thus drecreasingequilibriumoutput from Y0 to Y1.
5 5. Government Spending AD1 AD0 Y0 Y1 Assume tax rate is zero, And government spendingIncreases.With a MPC of 0.9,the multiplier is 10Income,outputAggregate demand45o lineAD0Y0AD1Y1A rise in governmentexpenditure G induce arise in output by ten timesthat amount
6 6. The Balanced Budget Multiplier According to the balanced budget multiplier, an increase in G accompanied by an increase in NT, has an expansionary effect on outputThis is because AD increase by the full amount of an increase in G but AD does not fall by the full amount in taxes as C falls by lessIf G and T rises by 200, Then AD rises by 200, YD fall by 200Assuming MPC = 0.75, AD should fall by 150Ultimately, there is a net increase in AD of 50
7 7. The Government BudgetThe budget deficit equals total government spendingminus total tax revenue; BD = G -NTIf government spending isindependent of incomeGG, NTbut net taxes depend onincome,As noted, the balanced budget multiplier states that anincrease in government spending plus an equal increasein taxes leads to higher equilibrium output.Balancedbudgetbut in surplus at high levelsthen the budget will be indeficit at low levels ofincomeIncome, output
8 8. Investment, Saving and Budget Without government, planned savings equal to planned investmentWith govt. in equilibrium, planned savings equal planned injections, S + NT = G + IThis implies S – I = G – NTThus, private sector surplus (S > I) must be matched by a government budget deficit (G > NT)
9 9. Deficits and the Fiscal Stance The size of the budget deficit is not a good measure of the government’s fiscal stance for the following reasonsBD can change for reasons other than fiscal policy, e.g. If I falls, Y falls as well as TFor given level of T and G, BD is higher in recession than in boomOfficial measures of the deficit treat the whole of the nominal interest paid by the government on the national debt as an item of G
10 10. Deficits and the Fiscal Stance The structural budget shows what the budget would have been if output had been at the full-employment level.The inflation-adjusted budget uses real not nominal interest rates to calculate government spending on debt interest.
11 11. Automatic Stabilizers & Discretionary Fiscal Policy Automatic Stabilizers are mechanisms in the economy that reduce the response of GNP to shocksfor example, in a recession:payments of unemployment benefits riseand receipts from VAT and income tax fallDiscretionary fiscal policy is decisions about tax rate and levels of government spending
12 12. Limits on Active Fiscal Policy Why can’t shocks to aggregate demandimmediately be offset by fiscal policy?Time lags: it takes timeto diagnose the problemto take actionfor the multiplier process to operateUncertaintythe size of the multiplier is not knownaggregate demand is always changingInduced effects on autonomous demandchanges in fiscal policy may induce offsetting effects in other components of aggregate demand
13 12. Limits on Active Fiscal Policy (2) Why doesn’t the government expand fiscalpolicy when unemployment is persistently high?The budget deficitconcern about inflation if the budget deficit growsMaybe we’re at full employment!unemployment may be (at least partly) voluntary
14 13. Foreign Trade and Income Determination Introducing exports (X) & imports (Z)It affects AD and multiplierTRADE BALANCEthe value of net exports (X - Z)TRADE DEFICITwhen imports exceed exportsTRADE SURPLUSwhen exports exceed importsEquilibrium is now whereY = C + I + G + X – Z
15 14. Exports, Imports and the Trade Balance Assume that exportsare independent ofincome,Exportsbut that imports increasewith incomeImportsX, ZAt higher income levels, there is a trade deficit.At relatively low income,exports exceed imports – there is a trade surplus.There is trade balance at income Y*, but there is noguarantee that this corresponds to full employment.Y*Income
16 15. Foreign Trade and the Multiplier K = 1 / 1 – (MPCT – MPZ) = 1 / 1 – MPCT + MPZ)The marginal propensity to importis the fraction of additional income that domestic residents wish to spend on additional imports.The effect of foreign trade is to reduce the size of the multiplierthe higher the value of the marginal propensity to import, the lower the value of the multiplier.
17 16. Investment, Savings, the Budget Deficit and Trade Deficit In equilibrium total injections = total withdrawalsS + NT + Z = I + G + XS – I = (G – NT) + (X – Z)Thus, S – I = Budget deficit/Surplus + Trade Deficit/Surplus