MACROECONOMIC 2

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The 4 Sectors of the Economy- Government Sector

Topic 4 (Part 3)

Government Sector

Governments influence AE through the conduct of fiscal policy.

Fiscal policy consists of changes in government purchases of goods and services (G) and taxation (T).

Government Purchases (G) is the value of goods and services purchased by the government at the federal, state and local levels

Transfer Payments (F) are payments from the government to households that do not require the recipient to provide a service in return (welfare support)

Government Spending = G + F

The Government pays for its spending by collecting Tax Revenue (R) and by borrowing and/or printing money.

Net Taxes (T) = R – F

Government Budgets

A government has a balanced budget in any year if its total expenditures equals its total revenue (mainly from T), i.e. G = T. Outlays equals receipts.

A government has a budget surplus if total expenditure is less than total revenue, i.e. G < T.

It has a budget deficit it total expenditure is greater than total revenue, i.e. G > T.

Fiscal Policy

Discretionary Fiscal Policy: deliberate changes in government spending and tax revenue used to help stabilise the economy.

Deliberate attempts to stimulate or constrain the level of economic activity, to ‘fine tune’ the economy.

Expansionary Fiscal Policy

Expansionary fiscal policy involves:

Increases in government spending

Lowering of taxes

A combination of the two

Thereby increasing the government budget deficit or decreasing the surplus.

Contractionary Fiscal Policy

Contractionary fiscal policy involves:

Decreases in government spending

Increasing of taxes

A combination of the two

Thereby reducing the government budget deficit or increasing the surplus.

Check Your Knowledge

Briefly explain and illustrate how discretionary fiscal policy can be used to close inflationary and recessionary gaps.

Government Sector

Changes in Government Spending

Ep2 = C + I + G

45° line

Ep1 = C + I

ΔG $5bn

ΔY=

k x ΔG = $10bn

Assume G increases by $5bn, and the MPC = 0.5

Changes in Government Spending

Government expenditure is subject to the multiplier. A given increase in G will increase equilibrium GDP by a greater amount. ΔY > ΔG.

ΔY = k x ΔG where k =

= (1/0.5) x $5b = $10b

Check Your Knowledge

Assume the consumption schedule for the economy is C=50+0.8Y, I=$5bn and G=$25bn. As E = Y in equilibrium:

Calculate the equilibrium level of income/output for this economy.

Calculate what will happen to equilibrium income and output if G falls to $5bn?

Briefly explain the significance of the slope of the consumption function to any change in autonomous spending.

If everyone in the economy increased their level of savings what do you predict will happen to the equilibrium level of output and income? Why?

Changes in Taxation

Assume government imposes a lump-sum tax - a tax that collects the same amount of tax revenue at each level of GDP or income.

T = Ta (exogenous or autonomous taxation)

C = Ca + cY → C = Ca + c(Y - T)

C = Ca + cY - cT

Consumption falls by –cTa

Tax multiplier (autonomous taxes only) kT= - c/s

Changes in Taxation

E2 = C + I + G

45° line

E3 = C + I + G

after T

-cΔTa

Ca - cTa

ΔY = = kT x ΔTa

Check Your Knowledge

Calculate and illustrate the impact on an aggregate expenditure function of a decrease of autonomous taxes valued at $36m if the slope of the consumption function was equal to 0.7.

Endogenous Taxation

T = Ta + tY

Ta: autonomous or exogenous component

t: extra tax paid on an extra dollar earned, i.e. the marginal tax rate

The bigger is t, the smaller is the MPC out of total income, the bigger the leakage from the expenditure flow, the smaller is the size of the multiplier, and hence the flatter is the AE curve.

Autonomous Taxes and Marginal Tax Rate

Leakages-Injections Approach

Taxes, like savings, are a leakages from the income expenditure flow. Government spending, like planned investment, is an injection of spending.

New equilibrium condition for the leakages injections approach changes from

S = I to S +T = I + G

Marginal leakage rate: fraction of income that is taxed or saved (or used for imports) rather than being spent on domestic expenditure.

Marginal leakage rate = s(1-t)+t

Fiscal Policy and National Savings

To invest a nation must save

National saving (NS) consists of private savings (S) plus public/government savings (T-G).

National saving is the amount available to finance domestic investment (I)

S + T = I + G

S + (T – G) = I

NS = I

If public savings go down (i.e. T – G < 0)

Private saving (S) must go up or Investment (I) will fall

What is More Effective – G or Ta

MPC is 0.75

k=1/s=1/0.25=4

kT=-c/s=-3

↑G by $20m = ΔY = k x ΔG = 4 x 20 = $80m expansion

↓T by $20m = ΔY = kT x ΔT = -3 x -20 = $60m expansion

There is another option – balanced budget multiplier

Balanced Budget Multiplier

Suppose G and Ta are increased by the same amount, at the same time.

The expansionary impact of the increase in G will be stronger than the contractionary impact of the change in Ta.

This will result in a net expansion of the economy.

Balanced Budget Multiplier

In a 3 sector economy where the MPC = 0.5

Expenditure Multiplier:

k = 1/s = 1/1-0.5 = 2

Taxation Multiplier:

kT = -c/s = -0.5/1-0.5 = -1

If G and T are each increased by $5m, the budget is left unchanged. What is the impact on the economy?

Balanced Budget Multiplier

Expansionary impact:

ke x change in G

2 x 5 = +$10m

Contractionary impact:

kT x change in T

-1 x 5 = -$5m

Net Impact = +$5m

Balanced Budget Multiplier

C + I + G (E2)

C + I (E1)

C + I + G after T (E3)

$5m

0.5 x $5

= $2.5m

$5m

Balanced Budget Multiplier

Non-Discretionary Fiscal Policy

Tax revenues vary directly with the level of GDP

Personal income taxes have progressive rates and result in more than proportionate increases in tax revenue as GDP and income increases – thus payroll tax payments increase as employment increases.

Unemployment benefits and other forms of social security payments by government decrease as income and GDP increase.

If net tax revenues rise when income is high and falls when income is low:

Budget Position = T – G = tY – G

Built-in/Automatic Stabilisers

Automatic stabilisers

increase the government deficit (reduce surplus) during a recession

increase the government surplus (reduce the deficit) during recovery

Automatic stabilisers act automatically to reduce the severity of the business cycle.

Built-in/Automatic Stabilisers

The built in stabilisers mean we cannot look at the budget deficit as a measure of whether government discretionary fiscal policy is expansionary or contractionary (ie fiscal stance).

The budget outcome is affected by the state of the economy.

Reducing a Deficit

1. Reduce government spending (G)

2. Increase autonomous taxation (Ta)

3. Increase the tax rate (t)

4. Increase in real income

Reducing a Deficit

T, G

T = Ta + tY

Check Your Knowledge

The three ways of reducing a government budget deficit are to

decrease government spending, reduce consumption, increase the tax rate.

increase government spending, decrease real income, reduce the tax rate.

decrease government spending, increase real income, reduce the tax rate.

decrease government spending, increase real income, increase the tax rate.

Should the Government Pursue Annually Balanced Budgets?

An annually balanced budget intensifies the business cycle.

Suppose the economy encounters unemployment and falling income.

tax receipts will automatically decline and transfer payments increase

to balance its budget, governments will need to increase taxes, decrease spending or do both. These policies are contractionary, each further dampens, rather than stimulates AD.

Public Debt: Gross vs. Net

The public debt is the amount of money owed by a government (or its financial liabilities). The major component of gross debt on the Australian Government’s balance sheet is Commonwealth Government Securities.

The gross debt is the same as the public debt.

The net debt subtracts out debt held inside the government, including government securities held by the Central Bank and any trust funds it holds. It is the sum of all financial liabilities (gross debt) of a government less its respective financial assets.

The public debt is also the sum of all fiscal deficits (and/or surpluses) over time:

Debt (end of 2017) = Debt (end of 2016) + Fiscal Deficit (during 2017)

Public Debt: Gross vs. Net

Gross debt indicates the magnitude of debt owed, but it does not show whether a government can repay that debt and provides limited detail about the overall financial health of a government.

This is where net debt is significant. If a government has a gross debt of 50 per cent of GDP, but has large amounts of cash and/or assets (low net debt), then it is in a much better position to handle this level of debt.

International Perspective: General government (gross) debt (Total, % of GDP)

OECD Data:https://data.oecd.org/gga/general-government-debt.htm

The Future Burden of the Government

What is the burden of government borrowing for investment projects like building highways or schools?

None, as long as the future return is greater than the social cost of the project and government is equally efficient as the private sector when undertaking these projects.

If some investment projects, like a rarely used highway, yield a very low return, then there will be future costs.

What about the burden of government borrowing to pay for consumption items?

Since government consumption spending has only current benefits, there will costs to pay in the future.

Future costs = interest plus debt principal repayment

Will the Government Remain Solvent?

How can we tell if the budget deficit is too high?

Key variable: Debt to nominal GDP ratio (D / PY)

Notation: The level of a variable is represented by a capital letter, while the growth rate of the variable is lowercase.

The government will be able to afford its debt if the debt to nominal GDP ratio is stable over time.

Growth of (D / PY) = d – (p + y)

Stability  growth of (D / PY) = 0  d = p + y

Multiplying by the size of the debt (D) on both sides dD = (p + y)D  the allowable deficit (ie. addition to debt) that is consistent with keeping the debt-GDP ratio constant

Result: D/PY remains constant if the budget deficit equals the outstanding debt times the growth rate of nominal GDP

The Solvency Condition

The basic limitation on the amount of government debt is that the government must pay interest on its debt.

But as long as nominal GDP is growing and interest rates are low, the government can borrow more to pay the yearly interest expense and still maintain a constant D / PY.

The solvency condition states that the government can meet its interest bill forever by issuing more bonds without increasing the debt-GDP ratio only if the economy’s growth rate (p + y) equals or exceeds its actual nominal interest rate (i).

3-Sector Equation Summary

where (T = Tα)

3-Sector Equation Summary

where (T = Tα + tY)