Topic 3 fiscal policy
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Topic 3: Fiscal Policy. Circular Flow Keynesian Economics Taxes and Government Spending. Economic Output Equation. Y = GDP = C + I + G + X – M Y = National Income C = Consumption I = Investment G = Government Spending X – M = Net Exports. Focus on National Income.

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Topic 3: Fiscal Policy

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Topic 3 fiscal policy

Topic 3: Fiscal Policy

Circular Flow

Keynesian Economics

Taxes and Government Spending


Economic output equation

Economic Output Equation

Y = GDP = C + I + G + X – M

  • Y = National Income

  • C = Consumption

  • I = Investment

  • G = Government Spending

  • X – M = Net Exports


Focus on national income

Focus on National Income

Y = C + I + G + X – M

  • In “equilibrium” total national expenditures equal total national income. Both are measures of “Output”


Focus on national income1

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


Let s go through these one at a time

Let’s go through these one at a time

Y = C + I + G


What is consumption

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


How much do people consume

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)


Consumption equation

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)


Marginal propensity to consume

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”


Consumption functions

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 )


What is investment

What is Investment?

Spending by investors (whom may be businesses, financial institutions, governments or households) on:


What is investment1

What is Investment?

  • Plant & Equipment


What is investment2

What is Investment?

  • New Residential Construction


What is investment3

What is Investment?

  • Inventories


Inventories

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


What is investment4

What is Investment?

Spending by investors (whom may be businesses, financial institutions, governments or households) on:

  • Plant & Equipment

  • New Residential Construction

  • Inventories


Calculating output

Calculating Output

Y = C + I + G

C = Cmin+ MPC ( Y – Tx)

Y = [Cmin+ MPC ( Y – Tx)] + I + G


Solving for equilibrium y

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


Solving for equilibrium y1

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


Solving for equilibrium y2

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


Solving for equilibrium y3

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


Solving for equilibrium y4

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


What have we shown

What have we shown?

  • National Income increases when:

    • MPC increases

    • Government spending increases

    • Taxes decrease

    • Investment increases


Converse is also true

Converse is also true

  • National Income decreases when:

    • MPC decreases

    • Government spending decreases

    • Taxes increase

    • Investment decreases


Keynesian multipliers

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)


Calculating keynesian multipliers

Calculating Keynesian Multipliers


Keynesian multipliers1

Keynesian Multipliers

  • For Investment

  • For Government Spending

  • For Taxes


Keynesian multipliers2

Keynesian Multipliers


Example

Example

  • If the MPC is 0.8, and G increases by 200:

  • Then Y increases by:


Example1

Example

  • If the MPC is 0.8, and Tx decreases by 200:

  • Then Y increases by:


Using fiscal policy

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


Using expansionary fiscal policy

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


  • Using contractionary fiscal policy

    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


  • Full employment level of income

    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


    Fiscal policy example 1

    Fiscal Policy Example 1

    • Suppose

      • C = 100 + 0.75 (Y-Tx)

      • I = 400

      • G = Tx = 200

    • What is National Income?

      • Y = 2200


    Fiscal policy example 11

    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?


    Fiscal policy example 12

    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?


    Fiscal policy example 2

    Fiscal Policy Example 2

    • Suppose

      • C = 200 + 0.5 (Y-Tx)

      • I = 500

      • G = Tx = 300

    • What is National Income?

      • Y = 1700


    Fiscal policy example 21

    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?


    Fiscal policy example 22

    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?


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