Chapter 22 Aggregate demand, fiscal policy, and foreign trade

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Chapter 22Aggregate demand, fiscal policy, and
foreign trade

• MIS 112 Spring 2004

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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
AD00.7Y300
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 AEautonomous demand
• The formula in Ch 21 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
AD00.7Y300
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
AD00.7Y300
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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Another derivation

• Y1-Y0 G1-G0MPC(Y1-Y0- (T1-T0))
• ?YY1-Y0 ?GMPC(?Y- ?T)
• As ?I is zero since ?G ?T
• ?Y ?GMPC(?Y- ?G) or
• ?Y ?GMPC?Y- MPC?G
• (1-MPC)?Y?G-MPC?G(1-MPC)?G
• ?Y?G or ?Y/?G 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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A numerical example
The budget deficit G - NT G - tY G200,t0.2
then BD 200 - 0.2Y
G, NT
Balanced budget
Income, output
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Investments, savings and the budget

• A fiscal policy suggestion
• If G is increased eq Y will increases and hence
  taxes increases
• Than Is it possible to reduce the budget deficit
  by raising G ?
• Iac Gac Sac NTac
• always holds whether the economy is in
  equilibrium or not

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• I G S NT
• planned leakages planned drawings
• holds only in equilibrium
• S - I G - NT
• desired savings - desired investment equals
  desired budget deficit
• When G? ? BD? why?
• G? ? AD? ? Y? ? YD?(t?1) ? C?,S?
• Since I is constant left hand side of the above
  equation? hence BD ?

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• Similarly when tax rates increase
• t ? ? AD ? ? Y? ? YD?(t?1) ? C?,S?
• hence left hand side of the above equation will
  decreased therefore budget deficit will fall

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• when government spending increased ?Ggt0 what is
  ?BD ?
• ?BD ?G - ?NT
• ?NT t?Y t . ?G
• 1-MPC(1-t)
• ?BD ?G - t . ?G
• 1-MPC(1-t)
• ?BD ?G(1 _ t )
• 1-MPC(1-t)
• the term in brakets 0 when t1 and gt0 when tlt1
• so ?BD gt0 when ?G gt0 or G is raised with the
  aim of reducing the budget defict

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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.
• Suppose I(desired investments)? ? AD? ?Y? ?
  NTtY? ? BDG-NT?
• although G and t are the same because income
  falls budget deficit raises
• in recessions BD is large as income is loweer
• in booms BD is lower
• By looking at a high BD it can be concluded that

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• By looking at a high BD it can be concluded that
  G should be reduced or a tax rate should be
  raised to eliminate the high BD
• This is wrong because the deficit exist because
  of recession not because of the fiscal policy

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Deficits and the fiscal stance

• The inflation-adjusted budget uses real not
  nominal interest rates to calculate government
  spending on debt interest.
• Interest payments are considered as a component
  of G
• real interest rate ir nominal interest rate in
  - inflation rate ?
• ir in - ?
• Suppose ? 10 in 12 then ir 2

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• for each 1 of outstanding debt government pays
  2 real interest
• inflation will increase next years tax revenues
  which facilitates to pay the high nominal rate of
  12
• from the governments point of view the real
  burden of debt is best measured by the real
  interest rate

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Automatic stabilizers

• mechanisms in the economy that reduce the
  response of GNP to shocks
• for example, in a recession
• I the investment demand may fall
• sticking to the previous example parameter
  MPC0.7, ?I100, without taxation t0.0
  multiplier3.33
• so the fall in output is ?Y-1003.33-333
• if a tax rate of t0.2 is imposed by the same
  fall in investment demand ?I-100
• output falls by ?Y1/(1-0.70.8)(-100)
• 2.27(-100)227

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Automatic stabilizers

• If an investment increase occurs the raise in
  output will also be damped by the taxation of
  income
• shocks are events like oil price shocks or wars
• they change the autonomous part of AD and hence
  shifts the AD schedule
• income tax,VAT are examples of automatic
  stabilisers

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Automatic stabilizers

• have great advantage
• they work outomatically to stabilise output
  - prevent output to fall to catastrophic levels-
  without requiring any change in fiscal policy
  decision of the government

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Active of discretionary fiscal policy

• Together with the automatic stabilisers
  government can apply active fiscal policy to
  stabilise output close to the full employment
  level
• raise spending or cut taxes when some component
  of AD are falling
• raising taxes and/or reducing spending when some
  components of AD are high

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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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• S - I G - NT in equilibrium
• but
• desired savings - desired investment equals
  desired budget deficit
• Sac - Iac Gac - NTac
• always true an accounting equation
• the budget deficit is financed by private sectors
  net savings
• some part of S finances investmets the rests
  finances government budget

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• Assuming economy is in equilibrium in every year
  so no difference between actual and desired
  quantities
• In 2000
• G2000200,NT2000140 so
• borrowing requirement BR2000 200-14060
• nominal interest in20, term of the debt is 1
  year
• so government will pay (10.2) in 2001
• 60 of which is principle 12 is interest
• at the end of 2000 on 31.12.2000 the outstanding
  debt 60, it is a stock variable

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• In 2001 governments budget is
• BR2001G2001-NT2001BR2000
• suppose G2001 228 NT2001 160
• BR2001 228 - 160 72 140
• if the inflation rate was 15
• real interest burden of outstanding debt is
  60(0.2-0.15)3 rather than 12
• suppose 80 of the 140 will be paid in 2002 the
  rest in 140-8060 in 2003, in25

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• So government will pay
• 80(10.25) 100 in 2002
• 20 of which is interest payment
• 60(10.25)2 601.562593.75 in 2003

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• In 2002 governments budget is
• BR2002G2002-NT2002BR2001
• suppose G2001 260 NT2001 190
• BR2001 260 - 190 100 170
• if the inflation rate was 15
• real interest burden of outstanding debt is
  80(0.25-0.15)8 rather than 20
• 90 of the 170 will be paid in 2003 the rest
  170-9080 in 2004 in30

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• Government will pay
• 90(10.30) 117 in 2003
• 27 of which is interest payment
• 80(10.30)2 801.69135.2 in 2003
• Notice that the total payment in 2003 will be 117
  (from 2002) 93.75 (from 2001)210.75

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Foreign tradeand income determination

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

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The difference between imports Z and exports X is
financed by selling some assets
Z
X - Z ?W ?W change in financial wealth of
thecountry
country
X
So if a county is in trade deficit for a long
time it must have enough foreign
exchange reserves to finance this deficit
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Exports, imports and the trade balance
X, Z
Income
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An illustrative example
X, Z
Income
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Foreign trade and the multiplier

• The marginal propensity to import
• is the fraction of additional income that
  domestic residents wish to spend on additional
  imports. (MPZ)
• AD C I G X - Z Y in eq
• MPCY I G X - MPZY
• MPCY - MPZY I G X
• MPCY - MPZY I G X
• (MPC-MPZ)Y AE

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• Y (MPC-MPZ)YAE
• Y-(MPC-MPZ) AE
• Y AE .
• 1-(MPC-MPZ)
• ?Y ? AE .
• 1-MPCMPZ
• ?Y 1 .
• ? AE 1-MPCMPZ

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Foreign trade and the multiplier

• multiplier 1 .
• 1-MPCMPZ
• The effect of foreign trade is to reduce the size
  of the multiplier
• the higher the value of the marginal propensity
  to import, the lower the value of the multiplier.
• Imports are automatic stabilisers
• reduces the responsiveness of output to shocks

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Open economy output determination
No foreign trase I300,C0.7YDG200,t0.2 AD00.7
0.8Y300200 Y01136
45o line
AD00.7Y300
Aggregate demand
County opens to world exprts X250 imports
Z0.21Y AD0 both rotates and raises to
AD1, Equilibrium output increases from Y0 to Y1.
At the new eq AD1 0.80.7Y300200250-0.21YY (1
-0.5611530.21)Y750 Y11153
Y0
Income, output
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Increasing exports
45o line
Aggregate demand
AD0
But at the same time imports will also
raise because they depend on output as wll
Y0
Income, output
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Increase in exports

• The equilibrium condition for an open economy is
• S NT Z I G X
• desired desired
• leakages injections
• when exports increases
• X? ? AD? ? Y? ? YD? ? NT?, S?,Z?
• as every thing in left hand side increases and in
  the new eq the equiality holds imports increase
  less then exports so X-Z? the net trade balance
  increases as a result of X?

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Reducing imports
If a country wants to reduces imports one way
to do that is to impose import taxes
45o line
AD1
Aggregate demand
MPZ will decrease AD0 rotates to
AD1, Equilibrium output raises from Y0 to Y1.
AD0
This is similar to the falling the tax rate we
ignore the effect of the import reduction
policy on export demand of foreigners
Y1
Y0
Income, output
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Decreasing imports

• Decreasing imports will increase output and
  employment
• higher domestic spending on domestically produced
  good will increase output and emplymet
• but dangerous
• if a country decreases imports by imposing import
  tax or quotas
• Other countries will do so
• therefore exports also will be decreased

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Summary of multipliers

• Multipliers is a measure of the dependent
  variables to a chance of independent or
  autonomous variables or model parameters
• multiplier ?dependent var.
• ?independent var.
• Examples of dependent variables
• output, consumption, saving, net taxes,
  imports...

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• Examples of independent variables
• autonomous expenditures
• investment demand, government spending, exports
• parameters
• tax rate, marginal propensity to consume MPC or
  marginal propensity to import MPZ
• ?Y/?AE autonomous expenditure multiplier of
  income or simply multiplier

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• ?C/?t tax rate multiplier of consumption
• ?S/?MPZ import multiplier of savinngs
• measures how savings changes when MPZ increases
  by one unit
• it is easy to derive autonomous expenditure type
  of multipliers without using calculus
• ?C/?G, ?NT/?I, ?Y/?X ...

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• Derive the export multiplier of budget deficit
  ?BD/?X in other words what is the change in
  budget deficit when exports increases by one unit
• BDG-NT ?BD-t ?Y
• ?BD/ ?X -t ?Y/ ?X -t(1/(1-mpcmpz)
• because ?Y/ ?X1/(1-mpcmpz)

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• In the 2000 stabilization program Turkish exports
  decreased by 100, government cut its expenditures
  by 50 and private sector decreased investments by
  50.
• CMPCYD,MPC0.8, NT 0.2Y, NT net tax, imports
  Z0.1Y
• a.What is the change in net exports in 2000, the
  first year of the stabilization program? (2 pnt)
• b.What is the change in budget deficit?

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• YAD mpcYGIX-mpzY
• ?Y mpc ?Y ?G ?I ?X-mpz ?Y
• ?Y 0.8(1-0.2) ?Y-50-50-100-0.1 ?Y
• ?Y(1-0.640.1) -200
• ?Y200/0.46-434
• ?TB ?X-0.1 ?Y-10043.4
• ?BD ?G-0.2 ?Y-500.2434