Topic 3: Fiscal Policy

1. Topic 3: Fiscal Policy Circular Flow Keynesian Economics Taxes and Government Spending

2. Economic Output Equation Y = GDP = C + I + G + X – M • Y = National Income • C = Consumption • I = Investment • G = Government Spending • X – M = Net Exports

3. Focus on National Income Y = C + I + G + X – M • In “equilibrium” total national expenditures equal total national income. Both are measures of “Output”

4. Focus on National Income Y = C + I + G • For now, we will also assume that net exports are zero. This is the case when X = M, or if the economy is closed (i.e., it doesn’t trade with others) • We will allow for trade later in the course

5. Let’s go through these one at a time Y = C + I + G

6. What is consumption? • The amount people (e.g., households) spend on newly produced goods and services • Cars • Books • Accountants • Food • Clothes • Beer • Pets • Tuition • Nanny • Garbage bags • Everything

7. How much do people consume? • Depends on people’s income • C is increasing in “disposable” (after-tax) income • Represent this using an equation. For example: C = 100 + 0.9 ( Y – Tx ) (This means that people consume 100, plus 90% of disposable income)

8. Consumption Equation • A general form of the equation: C = Cmin + MPC ( Y – Tx ) • Cmin = spending even when there is no income (must eat to survive) • mpc = “Marginal Propensity to Consume” • Y – Tx = disposable income (Tx is taxes and Y is income)

9. Marginal Propensity to Consume C = Cmin + MPC ( Y – Tx ) • Income can be spent on consumption, saved, or used to pay taxes. • MPC is the portion of disposable income that households spend on consumption • 1 – MPC is therefore the portion of disposable income households save. It is called the “marginal propensity to save”

10. Consumption Functions • If households always spend $750, plus 80% of their disposable income, then C = 750 + 0.8 ( Y – Tx ) • If households always spend $1000, plus 75% of their disposable income, then C = 1000 + 0.75 ( Y – Tx )

11. What is Investment? Spending by investors (whom may be businesses, financial institutions, governments or households) on:

12. What is Investment? • Plant & Equipment

13. What is Investment? • New Residential Construction

14. What is Investment? • Inventories

15. Inventories • Intermediate goods to be used in future production • Final good not yet sold • Inventories are important: • If people buy too little: companies are overproducing, inventories will rise, then firms slow down production • If people buy too much: companies don’t produce enough, inventories fall, then firms increase production

16. What is Investment? Spending by investors (whom may be businesses, financial institutions, governments or households) on: • Plant & Equipment • New Residential Construction • Inventories

17. Calculating Output Y = C + I + G C = Cmin+ MPC ( Y – Tx) Y = [Cmin+ MPC ( Y – Tx)] + I + G

18. Solving for Equilibrium Y • Suppose • C = 100 + 0.75 (Y-Tx) • I = 1000 • G = Tx = 500 (i.e., there is a balanced budget) • What is National Income? • Y = 4900

19. Solving for Equilibrium Y • Now, consumers become more optimistic about future income, and in response, they spend an extra 5% of their disposable income. Therefore, MPC goes from 0.75 to 0.8. • What is National Income? • Y = 6000

20. Solving for Equilibrium Y • Assume again that MPC = 0.8. • Now the government increases spending by 200 (G increases to 700) while keeping taxes unchanged at 500. • What is National Income? • Y = 7000 • Illustrate this change on the circular flow diagram

21. Solving for Equilibrium Y • Assume again that MPC = 0.8. • G = 700 • Now the government cuts taxes by 200 from 500 to 300. • What is National Income? • Y = 7800 • Illustrate this change on the circular flow diagram

22. Solving for Equilibrium Y • Now, MPC = 0.8, G = 700, Tx = 300. • Investment increases from 1000 to 1200 • What is National Income? • Y = 8800 • Illustrate this change on the circular flow diagram

23. What have we shown? • National Income increases when: • MPC increases • Government spending increases • Taxes decrease • Investment increases

24. Converse is also true • National Income decreases when: • MPC decreases • Government spending decreases • Taxes increase • Investment decreases

25. Keynesian Multipliers • Tell us how much Y changes given a change in I, or G, or Tx • Technically, they equal to: (But, you if you are not comfortable with calculus, don’t worry about these expressions)

26. Calculating Keynesian Multipliers

27. Keynesian Multipliers • For Investment • For Government Spending • For Taxes

28. Keynesian Multipliers

29. Example • If the MPC is 0.8, and G increases by 200: • Then Y increases by:

30. Example • If the MPC is 0.8, and Tx decreases by 200: • Then Y increases by:

31. Using Fiscal Policy • Fiscal policy: government’s attempt to influence national income by adjusting government spending and taxation • G and Tx are determined by government (congress) • Fiscal policy provides tools for the government to “slow down” or “speed up” the economy

32. Using Expansionary Fiscal Policy Expansionary Fiscal Policy • Policy designed to “speed up” the economy, encourage more output • Increasing G • Decreasing Tx • Expansionary policy increases Y • If there are unemployed/underutilized resources in the economy, then these resources can be used to increase production… unemployment decreases • If the economy is near full employment, then there is no unemployment to decrease… get inflation

33. Using Contractionary Fiscal Policy Contractionary Fiscal Policy • Policy designed to “slow down” the economy • Decreasing G • Increasing Tx • Contractionary policy decreases Y • Slowing down the economy can decrease inflation • But, it also will increase the unemployment

34. Full Employment Level of Income • At the “full employment” level of national income, the economy is at full employment, and there isn’t too much inflation • If national income exceeds the full employment level, there is too much inflation • If national income is below the full employment level, there is too much unemployment

35. Fiscal Policy Example 1 • Suppose • C = 100 + 0.75 (Y-Tx) • I = 400 • G = Tx = 200 • What is National Income? • Y = 2200

36. Fiscal Policy Example 1 • If the full employment level of National Income is 2600, then is expansionary or contractionary policy appropriate? • If the government wants to achieve the full employment level by increasing government spending, then by how much must G increase?

37. Fiscal Policy Example 1 • If the government wants to achieve the full employment level of 2600 by decreasing taxes, then by how much must Tx decrease? • If the government cuts taxes by more than this amount, then what happens to inflation?

38. Fiscal Policy Example 2 • Suppose • C = 200 + 0.5 (Y-Tx) • I = 500 • G = Tx = 300 • What is National Income? • Y = 1700

39. Fiscal Policy Example 2 • If the economy is currently experiences high inflation and low unemployment, then is expansionary or contractionary policy appropriate? • The government wants to use fiscal policy to achieve the full employment income of 1500 without changing taxes. What should it do?

40. Fiscal Policy Example 2 • The government wants to use fiscal policy to achieve the full employment income of 1500 without changing government spending. What should it do? • The government wants to use fiscal policy to achieve the full employment income of 1500 while maintaining a balanced budget. What should it do?