Chapter 21 Fiscal policy and foreign trade

1. Chapter 21Fiscal policy and foreign trade David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9th Edition, McGraw-Hill, 2008 PowerPoint presentation by Alex Tackie and Damian Ward

2. Some key terms Fiscal policy the government’s decisions about spending and taxes Stabilisation 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

3. Government in the income-expenditure model 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.

4. Government in the income-expenditure model AD=C+I+G Assume I and G is independent of Y. Transfer payment affects C or I and not included in G.

5. Government in the income-expenditure model Transfer payment are added to income and direct taxes are subtracted from it: Net taxes=t*Y-B Disposable income (YD) = (1-t)*Y+B

6. Government in the income-expenditure model Let’s assume autonomous consumption and transfer payments is 0 and mpc is 0.9 When Y increases by 1, then consumption will increase by 0.9*(1-t). MPC after tax (MPC’)=MPC*(1-t).

7. Fiscal policy? This seems to suggest that the government could influence aggregate output in the economy by raising AD from AD0 to AD1, AD1 thus raising equilibrium output from Y0 to Y1. Y1 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

8. Government Spending in Turkey (2005,2010) (Millions TL)

9. The Government Spending in Turkey (%) (2011)

12. The Debt in Turkey (Millions of dolars) (2002-2011)

13. Kaynak: Hazine Müsteşarlığı

14. Kaynak: Hazine Müsteşarlığı

15. The government budget If government spending is independent of income, NT Balanced budget but net taxes depend on income, then the budget will be in deficit at low levels of income G but in surplus at high levels. Y0 The balanced budget multiplier states that an increase in government spending plus an equal increase in taxes leads to higher equilibrium output. The budget deficit equals total government spending minus total tax revenue. G, NT Income, output

16. Automatic stabilisers 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

17. Limits on active 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 Why can’t shocks to aggregate demand immediately be offset by fiscal policy?

18. Limits on active fiscal policy (2) The budget deficit concern about inflation if the budget deficit grows Maybe we’re at full employment! unemployment may be (at least partly) voluntary Why doesn’t the government expand fiscal policy when unemployment is persistently high?

19. Foreign trade and 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

20. Exports, imports and the trade balance Imports Assume that exports are independent of income, but that imports increase with income. Exports At relatively low income, exports exceed imports – there is a trade surplus. Y* At higher income levels, there is a trade deficit. There is trade balance at income Y*, but there is no guarantee that this corresponds to full employment. X, Z Income

21. 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. 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. M=1/[1-(MPC’-MPZ)]