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

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 two extra variables in aggregate demand: taxes and expenditure

We analyse how the presence of the government changes the situation in the markets


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

As a result, most countries have put in place “output stimulus plans”, such as the 800 bill $ US plan There is currently a debate on the sustainability

of such deficits


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...


Aggregate demand and the government

The different multipliers

The role of the government in the savings-investment gap


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


These two variables usually 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 )


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


Income, output Y

Aggregate Demand (planned expenditure)

Z = C0 + c (Y – T ) + I + G

mpc: 0<c<1

Aggregate demand as a function of income

Autonomous demand (not a function of Y )

C0 - cT+ I + G

Aggregate Demand Z

Changes from last

week


45°

Effective expenditure

Y = Z

Keynesian Equilibrium Output

Y* Income, output Y

Aggregate Demand (planned expenditure)

Z = C0 + c (Y – T ) + I + G

Equilibrium on the goods market, with government

Aggregate Demand Z


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


We have the following market equation and equilibrium condition

Setting Y = Z

Isolating Y on the left hand side

ZY

GITYcCZ 0

GITYcCY 0

GIcTCcY 01


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

GIcTCc

Y

01

1

MultiplierAutonomous

demand (exogenous) cI

Y

1

1


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 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

GIcTCc

Y

01

1

cG

Y

1

1


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

GIcTCc

Y

01

1

c

c

T

Y

1


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.

c

c

T

Y

1

cc

c

1

1

1


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.

GIcTCc

Y

01

1

GITYcCZ 0


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:

GIcTCc

Y

01

1

dTc

cdGc

dY

11

1


Balanced budget multiplier In the case of a balanced budget increase we

have ΔG = ΔT

The balanced budget multiplier is equal to 1!

dTc

cdGc

dY

11

1

dGc

c

cdY

11

1

dGc

cdY

1

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”


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.


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


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

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)

G-T = S-I

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

Documents

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