E XERCISES FOR C HAPTER 6
7.7 Aggregate demand & equilibrium output
This completes our introduction to the government budget, fiscal policy, aggregate expenditure, and the economy. It recognizes the importance of another set of linkages and feedback effects within the macro economy. We have seen two ways in which the government sector affects aggregate expenditure and output. Government expenditure is a part of autonomous aggregate expenditure.
It affects the position of the AE function, equilibrium output, and the aggregate demand curve.
The net tax rate diverts income from the household sector to government revenue and reduces induced expenditures. It changes the slope of the AE function, the size of the multiplier. Together the change in autonomous government expenditure and the effect of the net tax rate on induced expenditure change equilibrium income, and the AD curve. The size and direction of the change depends on the government’s actual budget balance.
At the same time, conditions in the economy have significant effects on the government’s budget.
Recessions cause induced budget deficits and booms generate budget surpluses, both of which complicate the evaluation of the government’s policy stance. Furthermore feedback effects within the government budget provide revenue support for fiscal expansion and revenue resistance to fiscal restraint or austerity. These effects mean government budget cannot be judged in the same way a private or household budget might be.
7.7. Aggregate demand & equilibrium output 175
AS curve at P0, the fall in equilibrium determined by AD/AS is the same as the horizontal shift in AD.
Figure 7.11: AE, AD and equilibrium output
Y=AE
A1
A1+ [c(1 − t) − m]Y
A0
A0+ [c(1 − t) − m]Y
a) Equilibrium Y=AE AE
Real GDP
Ye′ Ye0
∆A
∆Y
P0 AS
AD1 AD0
b) Equilibrium AD=AS P
Real GDP
Ye′ Ye0
∆Y 45◦
Thegovernmentsector
a) Equilibrium with no Government
Autonomous expenditure = A0 Autonomous expenditure = 80
Induced expenditure = (c − m)Y Induced expenditure = (0.8 − 0.2)Y = 0.6Y
Aggregate expenditure = A0+ (c − m)Y Aggregate expenditure = 80 + 0.6Y
Equilibrium income: Y = AE Equilibrium income: Y= AE
Y = A0+ (c − m)Y Y= 80 + 0.6Y
Y[1 − (c − m)] = A0 Y[1 − 0.6] = 80
Y = A0/[1 − c + m] Y= 80 × 1/[1 − 0.6] = 80 × 2.5
Y= 200
b) Equilibrium with added government sector: G = 25, NT = 0.10Y
Autonomous expenditure = A0+ G0 Autonomous expenditure = 105
Induced expenditure = c(1 − t) − m Induced expenditure = [0.8(1 − 0.1) − 0.2]Y = 0.52Y
Aggregate expenditure = A0+ G0+ [c(1 − t) − m]Y Aggregate expenditure = 105 + 0.52Y
Equilibrium income: Y = AE Equilibrium income: Y= AE
Y = A0+ G0+ [c(1 − t) − m]Y Y= 105 + 0.52Y
Y[1 − [c(1 − t) − m]] = A0+ G0 Y(1 − 0.52) = 105
Y = [A0+ G0]/[1 − [c(1 − t) − m]] Y= 105/(1 − 0.52) = 105 × 2.08
Y= 218.4
In this example adding government expenditure G= 25 financed in part by a net tax rate t = 0.10 raised autonomous expenditure by 25 but lowered the multiplier from 2.5 to 2.08 with the result that equilibrium income increased by 18.4. Equilibrium income increased because the government sector ran a budget deficit. G was 25 but net tax revenue was only 0.10× 218.4 = 21.84.
Key Concepts 177
K EY C ONCEPTS
Canadian governments directly buy about 25 percent of GDP according to the national ac-counts data. They also spend about 17 percent on transfer payments to persons and business, including interest payments to holders of government bonds.
Government expenditure G on goods and services, including the public services provided to households and business is a policy variable and an autonomous component of aggregate expenditure.
Net taxes (NT = tY ), the revenue collected by government from households, are difference between taxes collected and transfers paid.
Disposable income is national income minus net taxes. Changes in disposable income cause changes in household consumption expenditure based on the MPC.
The net tax rate (t) reduces changes in disposable income relative to national income and reduces the marginal propensity to consume out of national income to c(1 − t). This lowers the slope of AE and the size of the multiplier.
Government expenditure and net taxes affect equilibrium national income by changing both autonomous expenditure and the multiplier.
The government budget describes what goods and services the government plans to buy during the coming year, what transfer payments it will make, and how it will pay for them.
Most spending is financed by taxes, but some revenue comes from charges for services.
The government budget balance is the difference between net revenues and government ex-penditures. Because net tax revenues depend on national income(NT = tY ) the actual budget balance is determined by the government’s budget plan and the level of national income. The actual budget balance will change with changes in national income.
A balanced budget has revenues equal to expenditures.
A budget surplus means revenues are greater than expenditures.
A budget deficit means revenues are less than expenditures.
Fiscal policy is the government’s use of its taxing and spending powers to affect aggregate demand and equilibrium GDP.
The structural budget balance (SBB) is an estimate of what the budget balance would be
if the economy were operating at potential output. Changes in the structural budget balance are indicators of changes in fiscal policy because they measure changes in expenditure and tax programs at a standardized income level.
The government’s tax and transfer programs are automatic (fiscal) stabilizers that reduce the size of the multiplier and the effects of transitory fluctuations in autonomous expenditures on equilibrium GDP.
Discretionary fiscal policies are changes in net tax rates and government’s expenditure in-tended to offset persistent autonomous expenditure shocks and stabilize aggregate demand and equilibrium output at potential output.
Public debt (PD) is the outstanding stock of government bonds issued to finance past govern-ment budget deficits minus the retiregovern-ment of governgovern-ment bonds in times of past governgovern-ment budget surpluses. The annual change in the public debt is∆PB= −BB.
Public debt ratio (PD/Y ) is the ratio of outstanding government debt to GDP, PD/Y .
Recent sovereign debt crises in Portugal, Ireland, Greece and Spain provide clear examples of the difficulties high and rising public debt ratios cause.
The government sector and fiscal policy are important determinates of aggregate demand and equilibrium GDP. Government expenditures are an autonomous policy variable. Net tax rates and policy affect the size of the multiplier. Changes in government expenditure and tax programs through the setting of the government’s budget affect AE, AD and equilibrium GDP.