Unit 4

The Government and

Fiscal Policy
School of Economics and Management
Hanoi University of Science and Technology
Learning Objectives
• Discuss the influence of fiscal policies on the economy.
• Describe the effects of three fiscal policy multipliers.
• Compare and contrast the budgets of the government
administrations.
• Explain the influence of the economy on the government
budget.

Government & Fiscal Policy 1

Contents
1. Government in the Economy

2. Fiscal Policy at Work: Multiplier Effects

3. The Economy’s Influence on the Government Budget

4. Deriving the Fiscal Policy Multipliers

Government & Fiscal Policy 2

Preliminary

fiscal policy The government’s spending and taxing policies.

discretionary fiscal policy Changes in taxes or spending that are the

result of deliberate changes in government policy.

monetary policy The behavior of the Central Bank concerning the

nation’s money supply.

Government & Fiscal Policy 3

Government in the Economy

Government Purchases (G), Net Taxes (T), and Disposable Income (Yd)

net taxes (T) Taxes paid by firms and households to the government
minus transfer payments made to households by the government.

disposable, or after-tax, income (Yd) Total income minus net taxes:

Y − T.
disposable income ≡ total income − net taxes

Yd ≡ Y − NT
Adding Net Taxes (T) and Government Purchases (G) to the
Circular Flow of Income
Aggregate Income and Aggregate Expenditure
The disposable income (Yd) of households must end up as either
consumption (C) or saving (S). Thus,
Yd  C + S
Because disposable income is aggregate income (Y) minus net taxes (T),
we can write another identity:
Y− T  C+ S
By adding T to both sides:
Y  C+ S+ T
Planned aggregate expenditure (AE) is the sum of consumption spending
by households (C), planned investment by business firms (I), and
government purchases of goods and services (G).
AE  C + I + G
Government & Fiscal Policy 6
Government Budget
budget balance The difference between what a government collects
in taxes and what it spends in a given period: T − G.

budget balance ≡ T − G

budget surplus if T − G > 0

budget deficit if T − G < 0

balanced budget if T − G = 0

Government & Fiscal Policy 7

New Consumption Function with Tax

To modify our aggregate consumption function to incorporate

disposable income instead of before-tax income, instead of
C = a + bY, we write

C = a + bYd

or

C = C0 + mpc(Y − T)

Our consumption function now has consumption depending on

disposable income instead of before-tax income.
Planned Investment
The government can affect investment behavior through its
tax treatment of depreciation and other tax policies.

Planned investment depends on the interest rate, both of

which we continue to assume are fixed for purposes of this
unit.

That is, I = I0
New AE Function
In the closed economy model:
C = C0 + mpc(Y − T)
I = I0 (exogenous)
G = G0 (exogenous)
T = T0 (exogenous)
So, AE = C0 + mpc(Y − T0) + I0 + G0

AE = (C0 + I0 + G0 − mpcT0 )+ mpcY

Government & Fiscal Policy 10

The Determination of Equilibrium Output (Income)

Y = AE = C + I + G
Finding Equilibrium for C = 100 + 0.75Yd, I = 100, G = 100, and T = 100
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

Planned Governmen Planned Unplanned

Output Net Disposable Consumption Saving Investment t Aggregate Inventory Adjustment
(Income) Taxes Income Spending S Spending Purchases Expenditure Change to Disequi-
Y T Yd ≡Y −T C = 100 + .75 Yd Yd – C I G C + I + G Y − (C + I + G) librium

300 100 200 250 − 50 100 100 450 − 150 Output ↑

500 100 400 400 0 100 100 600 − 100 Output ↑

700 100 600 550 50 100 100 750 − 50 Output ↑

900 100 800 700 100 100 100 900 0 Equilibrium
1,100 100 1,000 850 150 100 100 1,050 + 50 Output ↓
1,300 100 1,200 1,000 200 100 100 1,200 + 100 Output ↓
1,500 100 1,400 1,150 250 100 100 1,350 + 150 Output ↓
Equilibrium Output/Income
Because G and I are both
fixed at 100, the aggregate
expenditure function is the
new consumption function
displaced upward by
I + G = 200.

Equilibrium occurs at
Y = C + I + G = 900.
The Saving/Investment Approach to Equilibrium
To derive this, we know that in equilibrium, aggregate output (income) (Y)
equals planned aggregate expenditure (AE).

By definition, AE equals C + I + G, and by definition, Y equals C + S + T.

Therefore, at equilibrium:
C+S+T=C+I+G
Subtracting C from both sides leaves:
S+T=I+G

saving/investment approach to equilibrium:

S + (T – G) = I
Fiscal Policy at Work: Multiplier Effects
At this point, we are assuming that the government controls G and T. In
this section, we will review three multipliers:
Government spending multiplier
Tax multiplier
Balanced-budget multiplier

The Government Spending Multiplier

government spending multiplier The ratio of the change in the

equilibrium level of output to a change in government spending.

1 1
government spending multiplier  
MPS 1 − MPC
 Change of Government Spending
Finding Equilibrium after a Government Spending Increase of 50 (G Has Increased from 100 to 150 Here)

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
Unplanned
Planned Planned Inventory
Output Net Disposable Consumption Saving Investment Government Aggregate Change Adjustment
(Income) Taxes Income Spending S Spending Purchases Expenditure Y − (C + I + to
Y T Yd ≡Y −T C = 100 + .75 Yd Yd – C I G C+I+G G) Disequilibrium
300 100 200 250 − 50 100 150 500 − 200 Output ↑

500 100 400 400 0 100 150 650 − 150 Output ↑

700 100 600 550 50 100 150 800 − 100 Output ↑

900 100 800 700 100 100 150 950 − 50 Output ↑

1,100 100 1,000 850 150 100 150 1,100 0 Equilibrium

1,300 100 1,200 1,000 200 100 150 1,250 + 50 Output ↓

Government & Fiscal Policy 15

 The Government Spending Multiplier

Increasing government
spending by 50 shifts the AE
function up by 50.

As Y rises in response,
additional consumption is
generated.

Overall, the equilibrium level of

Y increases by 200, from 900 to
1,100.
The Tax Multiplier
tax multiplier The ratio of change in the equilibrium level of output to a
change in taxes.
 1 
 Y = (initial increase in aggregate expenditure)   
 MPS 
Because the initial change in aggregate expenditure caused by a tax change
of ∆T is (−∆T × MPC), we can solve for the tax multiplier by substitution:

Y = ( − T  MPC )  
1   MPC 
 = −T   
 MPS   MPS 
Because a tax cut will cause an increase in consumption expenditures and
output and a tax increase will cause a reduction in consumption expenditures
and output, the tax multiplier is a negative multiplier:

tax multiplier  − ( )
MPC

MPS
Finding Equilibrium after a tax decrease of 50 (T Has decreased from 100 to 60)

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

Planned Govern- Planned Unplanned

Output Net Disposable Consumption Saving Investment ment Aggregate Inventory Adjustment
(Income) Taxes Income Spending S Spending Purchases Expenditure Change to Disequi-
Y T Yd ≡Y −T C = 100 + .75Yd Yd – C I G C + I + G Y − (C + I + G) Librium

300 60 240 280 − 40 100 100 480 − 180 Output ↑

500 60 440 430 10 100 100 630 − 130 Output ↑

700 60 640 580 60 100 100 780 − 80 Output ↑

900 60 840 730 110 100 100 930 -30 Output ↑

1020 60 960 820 140 100 100 1020 0 Equilibrium
1,100 60 1.040 880 160 100 100 1080 + 20 Output ↓

1,300 60 1,240 1030 210 100 100 1230 + 70 Output ↓

1,500 60 1,440 1180 260 100 100 1380 + 120 Output ↓

Can you find the equilibrium Y?

Balanced Budget Multiplier
▪ The ratio of change in the equilibrium level of output to a
change in government spending where the change in
government spending is balanced by a change in taxes so as
not to create any deficit.
▪ The balanced-budget multiplier is equal to one: the change
in Y resulting from the change in G and the equal change in T
is exactly the same size as the initial change in G or T.

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Three Multipliers

Government & Fiscal Policy 20

Classification of Fiscal Policy
▪ Expansionary Fiscal Policy:
▪ The government increases spending (G) or reduce net tax (T)
▪ Equilibrium output: Rise
▪ Potential problems:
▪ government budget deficit
▪ Public debt
▪ Contractionary Fiscal Policy:
▪ The government reduces spending (G) or increase net tax (T)
▪ Equilibrium output: Fall
▪ Curbing high inflation
Government & Fiscal Policy 21
The Economy’s Influence on the Government Budget
▪ Tax Revenues Depend on the State of the Economy
▪ Tax revenue, on the other hand, depends on taxable income,
and income depends on the state of the economy, which the
government does not completely control.
▪ Some Government Expenditures Depend on the State of the
Economy
▪ Transfer payments tend to go down automatically during an expansion.
▪ Inflation often picks up when the economy is expanding. This can lead
the government to spend more than it had planned to spend.
▪ Any change in the interest rate changes government interest
payments.

Government & Fiscal Policy 22

VIETNAM’s GOVERNMENT BUDGET BALANCE
Sources: công khai ngân sách Nhà nước (https://ckns.mof.gov.vn)

Government & Fiscal Policy 23

Government & Fiscal Policy

Sources: công khai ngân sách Nhà nước (https://ckns.mof.gov.vn)

24
 Sources: công khai ngân sách Nhà nước (https://ckns.mof.gov.vn)

Government & Fiscal Policy 25

The Economy’s Influence on the Government Budget
▪ automatic stabilizers
▪ automatic changes in government
revenues and expenditures.
▪ They help stabilize the economy.
▪ In recessions, taxes fall and
expenditures rise, which creates
positive effects on the economy,
and in expansions, the opposite
happens.
▪ The government does not have to Pendulum Effects

change any laws for this to

happen.
Government & Fiscal Policy 26
The Economy’s Influence on the Government Budget
▪ automatic destabilizer
▪ inflation can be considered to be an automatic destabilizer
▪ Government spending increases as inflation increases, which
further fuels the expansion, which is destabilizing.
▪ If inflation decreases in a recession, there is an automatic
decrease in government spending, which makes the recession
worse.
▪ fiscal drag
▪ The negative effect on the economy that occurs when average
tax rates increase because taxpayers have moved into higher
income brackets during an expansion.

Government & Fiscal Policy 27

The Economy’s Influence on the Government Budget

▪ full-employment budget What the government budget would

be if the economy were producing at the full-employment level
of output.
▪ structural deficit The deficit that remains at full employment.
▪ cyclical deficit The deficit that occurs because of a downturn
in the business cycle.

Government & Fiscal Policy 28

Practice 1
For the data in the following table, the consumption function is C = 800 +
0.6(Y – T). Fill in the columns in the table and identify the equilibrium output.
Practice 2
For each of the following sets of data, determine if output will
need to increase, decrease, or remain the same to move the
economy to equilibrium:
a. Y = 1,000; C = 150 + 0.5(Y – T); I = 100; G = 200; T = 180
b. Y = 1,250; C = 200 + 0.7(Y – T); I = 80; G = 250; T = 240
c. Y = 1,500; C = 400 + 0.8(Y – T); I = 250; G = 200; T = 150
d. Y = 1,500; C = 300 + 0.75(Y – T); I = 200; G = 200; T = 150

Government & Fiscal Policy 31

Practice 3
Assume the following for the economy of a country:
Consumption function: C = 50 + 0.85Yd
Investment: I = 80
Government spending: G = 50
Disposable income: Yd = Y - T
Net taxes: T = - 10 + 0.1Y
Equilibrium: Y = C + I + G
a. Solve for equilibrium income.
b. What happens to the economy when the marginal propensity to save
increases to 0.2?
Government & Fiscal Policy 32