Chapter 22 Aggregate demand, fiscal policy, and foreign trade

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Chapter 22Aggregate demand, fiscal policy, and
foreign trade

• David Begg, Stanley Fischer and Rudiger
  Dornbusch, Economics,
• 6th Edition, McGraw-Hill, 2000
• Power Point presentation by Peter Smith

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Some key terms

• Fiscal policy
• the governments decisions about spending and
  taxes
• Stabilization policy
• government actions to try to keep output close to
  its potential level
• Budget deficit
• the excess of government outlays over government
  receipts
• National debt
• the stock of outstanding government debt

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Government

• Government
• collects direct taxes on factor income
• wages, profit, rent Td
• collects indirect taxes (sales taxes) on sales Te
• in Turkey KDV (katma deger vergisi)
• Spends on goods and services G
• wages of civil servants, military expenses,
  health, education, all equipment

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• Transfer payments or benefits
• wages of retired, unemployment subsidies,
• subsidies to private firms and state owned firms
  (in Turkey KITs kamu iktisadi tessekkulleri and
  state banks kamu bankalari Ziraat Bankasi)
• transfer payments do not add to GDP neither to
  national income not to national output.
• Not added to GDP no corresponding value added
• taxes and transfers redistribute income from
  people being taxed towards people being
  subsidized

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Government in the circular flow
YD
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Government in the income-expenditure model

• Assumptions
• No indirect taxes
• Cumbersome to distinguish GDP at market prices
  and GDP at basic prices
• No foreign trade
• Aggregate demand
• AD C I G
• G desired government spending or government
  demand of goods and services
• G is fixed in the short run independent of level
  of income so G is autonomous as well

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Government in the income-expenditure model

• Net taxes
• NT Td-B
• Disposable income YD
• YD Y NT
• Net taxes are proportional to national income
• NT tY
• Disposable income becomes
• YD Y tY (1-t)Y

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Government in the income-expenditure model

• Consumption demand is proportional to disposable
  income ignoreing the autonomous term
• C MPCYD
• C MPC(1-t)Y
• We can define MPC MPC(1-t) then
• C MPCY

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An Example
tax rate t0.2 then NT0.2Y a linear function of
output or factor income
YD(1-0.2)Y YD0.8Y
MPC0.7 then C0.7YD0.70.8Y C0.56Y
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Government in the income-expenditure model

• AD MPC(1-t)YIG
• slope intercept
• Direct taxes
• affect the slope of the consumption function
• and hence the slope of the AD schedule.
• Government expenditure affects the position of
  the AD schedule

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Fiscal policy?
45o line
Aggregate demand
AD0
But this ignores some important issues prices,
interest rates, and the need to fund the
government spending.
Y0
Income, output
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Example
45o line
Aggregate demand
AD00.7C300
AD10.7Y300200 Think it as if autonomous
exp Increased by 200 Multiplier1/(1-MPC)1/0.3
Multiplier3.33 so ?Y3.33 ?G3.33200666 Y11
0006661666
Y0
Income, output
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The multiplier with proportional taxes

• The multiplier relates to the changes in
  autonomous demand to changes in income or output
  ?Y/ ?E
• AD MPC(1-t)YIGMPCYAEY in eq
• where Eautonomous demand
• The formula in Ch 20 is still valid but we must
  use MPC MPC(1-t)
• multiplier ___1____
• 1-MPC
  
  
  

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The effect of net taxes on output

• Only tax rate t changes
• What is the change in Y or ? Y/ ? t
• ADGIMPC(1-t)Y
• At equilibrium ADY then
• Y GIMPC(1-t)Y AEMPC(1-t)Y
• where AEGIautonomous expenditure
• The equilibrium output is
• Y1-MPC(1-t) AE
• Y AE/1-MPC(1-t)

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• Y AE/1-MPC(1-t)
• Therefore
• raising the tax rate will reduces equilibrium
  income
• decreasing the tax rate will raises equilibrium
  income

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Derivation of tax rate multiplier

• Tax rate multiplier
• dY lim?t? 0 ?Y
• dt ?t
• dY _ AE MPC
• dt 1-MPC(1-t)2

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Example
G0,t0 no tax I300,C0.7YD AD00.7Y300 Y01000
45o line
AD00.7C300
Aggregate demand
gov. rises tax rate t0.2 AD0 rotates to
AD1, Equilibrium output falls from Y0 to Y1.
At the new eq AD10.80.7Y300Y (1-0.56)Y300 Y1
682
Y0
Income, output
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Combined effect of government spending and
taxation
G0,t0 no tax I300,C0.7YD AD00.7Y300 Y01000
45o line
AD00.7C300
Aggregate demand
gov. raises tax t0.2 gov. raises exp G200 AD0
both rotates and raises to AD1, Equilibrium
output increases from Y0 to Y1.
At the new eq AD10.80.7Y300200Y (1-0.56)Y50
0 Y11136
Y0
Income, output
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Balance Budget Multiplier

• Assume taxes are also independent of income
  (autonomous)
• so disposable income is
• YD Y-T and CMPC(Y-T)
• AD IGCIG MPC(Y-T)
• Government budget deficit is G-T
• Government raises both G and T by the same amount
  so budget deficit dose not change ?G ?T

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• What is the multiplier ?Y/ ?G or ?Y/ ?T ?
• At equilibrium YAD
• YIGMPC(Y-T) initially
• Y0 IG0-MPCT0
• 1-MPC
• At the new equilibrium
• Y1 IG1-MPCT1 where G1G0?G
• 1-MPC T1T0?T or
• 
  T1T0?G

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• ?YY1-Y0
• IG1- MPCT1 _ IG0- MPCT0
• 1-MPC 1-MPC
• G1-G0 MPC(T1-T0)
• 1-MPC
• ?G MPC?G ?G(1-MPC)
  
  
• 1- MPC 1-MPC
• ?G
• So ?Y?G or balance budget multiplier
• ?Y/?G ?Y/?T 1

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A graphical illustrative of the multipliers
Balanced budget multiplier ?G?T1,MPC0.7,?Y?
?G1,MPC0.7, ?Y?
?Y
?G
?C
1
1
1
1
0.7
0.7
-0.7
1
0.7
0
0.7
0.7
0.49
0
0
0
0.49
0
0.7
0.343
?Y1000... ?C0
?Y10.70.720.73... ?C0.70.720.73...
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The government budget
The budget deficit equals total government
spending minus total tax revenue.
G, NT
Income, output
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Deficits and the fiscal stance

• The size of the budget deficit is not a good
  measure of the governments 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.

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Automatic stabilizers

• mechanisms in the economy that reduce the
  response of GNP to shocks
• for example, in a recession
• payments of unemployment benefits rise
• and receipts from VAT and income tax fall

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Limits on active fiscal policy
Why cant shocks to aggregate demand immediately
be offset by fiscal policy?

• Time lags it takes time
• to diagnose the problem
• to take action
• for the multiplier process to operate
• Uncertainty
• the size of the multiplier is not known
• aggregate demand is always changing
• Induced effects on autonomous demand
• changes in fiscal policy may induce offsetting
  effects in other components of aggregate demand

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Limits on active fiscal policy (2)
Why doesnt the government expand fiscal policy
when unemployment is persistently high?

• The budget deficit
• concern about inflation if the budget deficit
  grows
• Maybe were at full employment!
• unemployment may be (at least partly) voluntary

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Foreign tradeand income determination

• Introducing exports (X) imports (Z)
• TRADE BALANCE
• the value of net exports (X - Z)
• TRADE DEFICIT
• when imports exceed exports
• TRADE SURPLUS
• when exports exceed imports
• Equilibrium is now where
• Y C I G X - Z