Government intervention and fiscal policy

Government intervention and fiscal policy Adding a government to the goods market equilibirum

Government intervention and fiscal policy • Today we examine a simple extension to last week’s analysis of the equilibrium in the goods market. • A specific agent is introduced (the government), which controls extra two variables in aggregate demand: taxes and expenditure • We analyse how the presence of the government changes the situation in the markets

Government intervention and fiscal policy • The debate about role of the government in influencing the goods market equilibrium is visible in the current affairs: • Most economies are in recession/depressed, with a low level of output relative to their potential • Most agents are asking for government intervention to fill this gap • As a result, most countries are planning “output stimulus plans”, such as the 800 bill $ US plan

Government intervention and fiscal policy • But there are questions around this: • Why is it necessary for the government to intervene is such circumstances (i.e. Not a matter of ideology) ? • How big must the intervention be ? • Why does the debate around government more expenditure vs. tax cuts matter ? • Simple models can actually explain all this quite well...

Government intervention and fiscal policy Aggregate demand and the government The different multipliers The role of the government in the savings-investment gap

Aggregate demand and the government • The government controls two variables that were omitted last week: • Government spending G • Taxes T • These variables represent the government's budget • If G - T > 0 there is a budget deficit • If G - T < 0 there is a budget surplus • If G - T = 0 the budget is balanced

Aggregate demand and the government • These two variables enter aggregate demand as follows: • First, government spending enters aggregate demand directly: Z = C + I + G • Second, taxes T are paid by agents out of their income, thus reducing their disposable income C = C0 + c(Y - T)

Aggregate demand and the government • As a result, the detailed aggregate demand equation becomes: Z = C0 + c(Y – T) + I + G • We still consider investment to be exogenous (for the moment) • The equilibrium condition on the market does not change: it still is Y = Z

Aggregate demand and the government Aggregate demand as a function of income Aggregate Demand Z Aggregate Demand (planned expenditure) Z = C0 + c(Y – T) + I + G mpc: 0<c<1 Changes from last week Autonomous demand (not a function of Y) C0- cT+ I + G Income, output Y

Keynesian Equilibrium Output 45° Aggregate demand and the government Equilibrium on the goods market, with government Aggregate Demand Z Effective expenditure Y = Z Aggregate Demand (planned expenditure) Z = C0 + c(Y – T) + I + G Income, output Y Y*

Aggregate demand and the government • So the aggregate demand curve and the market equilibrium diagram solve the same way as last week. • This means that one can find the equilibrium level of output Y* the same way as we did last week • Set Y = Z • Solve for Y* by isolating output on the left-hand-side of the equation

Aggregate demand and the government • We have the following market equation and equilibrium condition • Setting Y = Z • Isolating Y on the left hand side

Aggregate demand and the government • This gives the equilibrium level of output • One can see at this point that the main effect of the government intervention: • Is not really to change the size of the multiplier • The government, however, can influence the size of the autonomous demand in the economy Multiplier Autonomous demand (exogenous)

The different multipliers • Last week, we saw that there was an investment multiplier ΔY/ΔI • Equal to 1/(1-c) • Referred to as “the” multiplier • In fact, there are several sorts of multipliers • Last week, Investment was the only exogenous variable • Introducing G and T means more multipliers • Will see some again when we introduce international trade.

The different multipliers • The spending multiplier • Corresponds to the increase in output following an increase in government spending G • Given equilibrium output: • It is equal to • This is the same as last week’s investment multiplier

The different multipliers • The tax multiplier • Corresponds to the change in output following an increase in taxes T • Given equilibrium output: • It is equal to • This is a “new” multiplier, different from last week

The different multipliers • The tax multiplier • This multiplier is negative • An increase in taxes leads to a fall in output • It is smaller in absolute value than the spending multiplier • Tax cuts aren’t as effective as government spending in stimulating output.

The different multipliers • The tax multiplier • Let’s go back to the aggregate demand and the equilibrium output to see why: • Increased government spending G enters aggregate demand directly, but tax cuts enter indirectly, through disposable income (Y-T) • So some of the tax cut is directly saved, which reduces the multiplier effect.

The different multipliers • Balanced budget multiplier • The fact that the tax and spending multipliers are different sizes means that there is a balanced budget multiplier • Let’s start with a balanced budget G=T • The net effect of a change in spending and taxes is:

The different multipliers • Balanced budget multiplier • In the case of a balanced budget increase we have ΔG = ΔT • The balanced budget multiplier is equal to 1

The role of the government in the S-I gap • So we have established that the government can change the equilibrium level of output: • By varying the level of its deficit (G-T) • Several policy options are available for “fine-tuning”: changes in taxes, in spending, even in the absolute size of the budget. • But surely, budget deficits are a bad thing? • Like every economic agent, the state needs to balance its books, so it should keep G=T • This is known as the “treasury view”

The role of the government in the S-I gap • But this view ignores the fact that the state is a special agent, and that fiscal policy plays a central role in the economy. • This can be understood by examining the 2nd interpretation we saw last week: • The Y=Z equilibrium condition can always be interpreted as a savings = planned investment condition • But first of all, we need to work out this alternative equilibrium condition.

The role of the government in the S-I gap • Expenditure (Aggregate demand) is equal to: Z= C + I + G • Income can be divided up into: Y = C + S + T • At equilibrium we have Y=Z . This gives: C + I + G = C + S + T I + (G-T) = S • Alternatively: G-T = S-I Planned private investment Public investment Planned savings

The role of the government in the S-I gap G-T = S-I • If I > S (planned investment higher then planned savings) • The state can bring the economy to equilibrium by running a surplus (G<T), which supplies extra (public) savings • If I < S (planned investment lower then planned savings) • The state can bring the economy to equilibrium by running a deficit (G>T) which “mops up” the excess savings with public investment

The role of the government in the S-I gap G-T = S-I • What about the current situation? • Planned investment is at a record low: because of the recession (and expected depression) firms are cutting back on investment plans. • Planned savings are high: agents are anxious about the future or realise the high levels of private debt need to be paid back. • So large public deficits are needed to bring these economies back to equilibrium • Trying to balance the budget NOW would only prolong the situation (like in the 1930’s)

Government intervention and fiscal policy