Unit 4
Unit 4
Learning Objectives
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Contents
1. Government in the Economy
Preliminary
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Government in the Economy
discretionary fiscal policy Changes in taxes or spending that are the
result of deliberate changes in government policy.
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.
Yd ≡ Y − T
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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
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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
balanced budget if T − G = 0
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New Consumption Function with Tax
C = a + bYd
or
C = C0 + mpc(Y − T)
Planned Investment
The government can affect investment behavior through its
tax treatment of depreciation and other tax policies.
That is, I = I0
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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
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)
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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.
Therefore, at equilibrium:
C+S+T=C+I+G
Subtracting C from both sides leaves:
S+T=I+G
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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
1 1
government spending multiplier
MPS 1 MPC
(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 ↑
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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.
tax m ultiplier
M PC
M PS
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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)
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Three Multipliers
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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.
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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
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The Economy’s Influence on the Government Budget
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Practice 1
For the data in the following table, the consumption function is C = 800 +
0.61Y - T2. 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
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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?
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