The government and Fiscal Policy

Reference: McEachern (7e), Chapter 12

1. The Role of the Government

There has been much controversy over the role of the government in the economy.

a. The government should intervene in the economy. (John Maynard Keynes)
At one end of the spectrum is the Keynesians who believe that the macro economy is likely to fluctuate too much if left on its own and the government should play an important role in stabilizing the fluctuations in the business cycle. These ideas can be traced to Keynes’s analysis in The General Theory of Employment, Interest and Money which suggests the governments can use their tax and spending powers advantageously to increase aggregate expenditure in times of recession or depression.

b. The government should leave the economy alone. (Adam Smith)
On the other end of the spectrum, Adam Smith and Milton Friedman and others advocated that the government should not intervene in the economy and promoted a free-enterprise, laissez-faire type of economic system which allows market forces to determine the level of output, employment and price level.

Despite the two opposite views, many agree that governments are important actors in the economies of all countries. Singapore provides one of the best examples where the government has been very active in shaping and reshaping the economy to achieve its current “developed nation” status.

The Government intervenes in the economy in many ways. But, there are two primary policies through which the government affects the economy. The first is Fiscal Policy and the other is Monetary Policy.

Definition of Fiscal Policy
Regarding government purchases of goods and services.
Regarding taxes
Regarding transfer payment
Fiscal policy is the overall program for directing government spending and taxation for the purpose of keeping the actual GNP close to the potential full employment GNP, but without overheating the economy and causing inflation.
Government spending (G)
Taxes(T)
Are one of the source of government income
Eg personal income tax ,corporate tax,property tax,etc
Note other source of government income includes fees and charges,investment n interest income.

The fiscal policy tools that the Government uses include taxes, expenditures and transfer payments to achieve desired economic goals that affect real GNP, employment, the price level, and economic growth.




3. Types of Fiscal Policy

The prescriptions of fiscal policy are straight forward. To counter recessionary conditions, the government adopts an expansionary fiscal policy. And to counter inflationary conditions, the government adopts a contractionary fiscal policy.

Expansionary Fiscal Policy
Either INCREASE G or DECREASE T or BOTH
IMPLEMENTED DURING RECESSIONARY PERIODS WITH A AIM TO INCREASE PRODUCTION,EMPLOYMENT AND INCOME
This involves increasing governent purchases of goods and services, decreasing net taxes, or some combination of the two for the purpose of increasing aggregate demand and expanding real output. This will result in a budget deficit. The expansionary policy is normally adopted during periods of economic downturn and recession when the economy produces below its capacity, which is sometimes called the recessionary gap. As the spending by the government is normally large, it has a stimulative effect to prop up the economy and consumer confidence. It also lowers taxes to encourage investment and spending.

Contractionary Fiscal Policy
DECREASE G OR INCREASE T OR BOTH
IMPLEMENTED DURING INFLATIONART PERIODS OR WHEN THE ECONMY IS OVERHEATED
This refers to the decrease in government purchases of goods and services, and increase in net taxes, or some combination of the two for the purpose of decreasing aggregate expenditure. This may result in a budget surplus. The contractionary fiscal policy is normally adopted during periods of high inflation. High inflation can hurt consumers’ spending, producers’ production costs and export price competitiveness.

Net taxes
Taxes paid by firms and households to the government minus Transfer payments made to households by the government.
4. The Government Budget-itemizes its estimated source of revenue and spending

The Government Budget is a (annual)financial plan that indicates its estimated revenue and expenditure for a financial year. The government uses the national budget to adopt either an expansionary (Budget Deficit) or a contractionary fiscal policy (Budget Surplus) depending on the prevailing economic conditions and its objectives. There are basically three types of budget:

Balanced Budget: G = T
Government spending and taxes are increased or decreased simulataneously by equal amounts
b. Budget Surplus: G < T
Expenditure is less than taxes.
c. Budget Deficit: G > T

G refers to Government Spending/Purchases of goods and services.
T refers to taxes paid by firms and households to the government minus transfer payments made to households by the government.

Taxes form the major source of income for the government to finance its spending.

The most important thing to remember about taxes is that ultimately they are paid by people, or by households and firms. Taxes may be imposed on transactions, institutions, property, meals, and all other kinds of other things, but in the final analysis, they are paid by individuals or households. Although there are different types of taxes, we will look at the simpler version, the “Lump-Sum Tax” which is levied independently of income. Hence, we assume T as “Lump-Sum Taxes”.


5. THE TWO-SECTOR MODEL

a. AE = C + I
where C = a + bY
and Y = C + S
(Income)

b. At Equilibrium :

Y = AE
Y = C + I


6. THE THREE-SECTOR MODEL

a. AE = C + I + G
where C = a + b Yd
or C = a + b (Y – T)
and Y = C + S + T
or Yd = C + S
Yd = Disposable Income

Assume T are “Lump – Sum Taxes”

Y = Income
S = Saving
Yd = Disposable Income
T = Taxes
C = Consumption
I = Investment
G = Government Spending/Purchases
Assume T are “Lump Sum taxes”
Stop at A

b. At Equilibrium :

Y = AE
Y = C + I + G






7. NUMERICAL ILLUSTRATION :

Given : C = 100 + 0.75 Yd
I = 100
G = 100
T = 100


Y

Yd

C

AE
Change in
Unplanned
Inventory
Adjustment
To
Disequilibrium
700
600
550
750
-50
Increase of Y
900
800
700
900
0
Equilibrium
1100
1000
850
1050
50
Decrease of Y


8. THE LEAKAGES / INJECTIONS APPROACH TO EQUILIBRIUM

Leakages : Net Taxes (T)
Household Saving (S)

Injections : Govt Purchases (G)
Private Investment ( I)

At Equilibrium :

Y = AE
C + S + T = C + I + G
S + T = I + G

9. FISCAL POLICY AT WORK : THE MULTIPLIER EFFECTS

THE GOVERNMENT SPENDING MULTIPLIER (GSM)

Definition:

The ratio of the change in the Eqm Level of Output to a change in Government Spending

The concept of the multiplier is better explained by the snowball effect. Imagine a snowball rolling down a hill. It gets bigger and bigger before it gets to the bottom of the hill. The multiplier is the impact a certain amount of spending (marginal propensity to consume or MPC) in the economy percolates in changing the GNP. Imagine that the government decides to buy 100 fighter jets. The company that produces the fighter jets has to hire more engineers and workers. All these workers that now have paychecks will in turn spend more money at the malls, restaurants and music shops. The owners of these stores in turn will spend more money and the process will continue. The multiplier process entails using a formula:
1 1
GSM = ----------- or ------
1 – MPC MPS

For example, if we use the MPC of Singapore of 95%, the multiplier is 20.

GSM = 1/( 1 – 0.95 ) = 20

Example: Assume that country A is going through a recession and hence operating below its capacity. If the gap between the actual GNP and the potential GNP is $50 billion and if the GSM is five (because the economy-wide MPC equals 0.8), then it will be sufficient for the government to stimulate the economy with only a $10 billion increase in spending, letting the multiplier effect do the rest.

Summary of the GSM Multiplier Process

a. Find MPC first.

b. Use formula 1
-----------
1 – MPC

c. Apply formula to change in spending by the Government.

At eqm,Y-AE
Y=C+I+G
Y=200+0.6(Y-T) +60 +80
Y-200 +0.6(Y-100) +60 +80
Y=2--+0.6Y+60 +60+80
Y-0.6Y=280
0.4Y=280
Y=280/0.4
Y=700

Let’s Practise:

Numerical Illustration:

Given: C = 200 + 0.6 Yd
I = 60
G = 80
T = 100

Calculate the Eqm Level of Output.
If Government Spending increases by 100, calculate the New Eqm Level of Output.
GSM=1/MpS
=1/0.4
=2.5
Increase in G=1oo
Therefore,increase in Y =increase in GxGSM
= 100x2.5
=250
New eqm output=orginal eqm Y+ increase in Y
=700 +250
=900







THE TAX MULTIPLIER ( TM )

Definition:

The ratio of the change in the Eqm Level of Output to a change in Taxes

Change in Eqm Y
TM = ------------------------
Change in T

Formula:
MPC 1
TM = – ---------- or 1 – -------

MPS MPS


Note :
i) The Tax Multiplier is always negative because of the negative/inverse relationship between the change in T and the change in Eqm Y.

Increase in T à Decrease in Eqm Y
Decrease in T à Increase in Eqm Y

ii) The Tax Multiplier is numerically smaller than the Government Spending Multiplier by one.

- When G changes, there is an immediate and direct initial impact on the AE.
- When T changes, there is a delayed and indirect initial impact on the AE (through Yd and C).

Numerical Illustration:

Compare the initial impact on the AE of an Increase in G of 100 with a Decrease in T of 100. (Assume MPC = 0.8)







SUMMARY


Change in I à
Change in
Change in G à Eqm Y

Change in T à


B U T

Change IS I
in GREATER Change in G
Eqm Y THAN T

Because of the MULTIPLIER EFFECT
FORMULAE


Investment Multiplier

1 1
------------- or -----------
1 – MPC MPS


Government Spending
Multiplier

1 1
------------- or -----------
1 – MPC MPS


Tax
Multiplier

MPC 1
– ---------- or 1 – ---------
MPS MPS



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