Fiscal policy in the goods market. Screen 1

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Clifford Davis
6 years ago
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1 Fiscal policy in the goods market Screen 1 In this presentation we look at the impact of fiscal policy on the goods market. Make sure that you are thoroughly familiar with the goods market before you start this session. We first look at what fiscal policy is, and then at the impact of an expansionary and contractionary fiscal policy. We then compare the impact of an increase in government spending with that of an increase taxation. Finally we explain how fiscal policy can be used to reach full employment in the goods market. Screen 2 Fiscal policy is the government's policy in respect of the nature, level and composition of government spending, taxation and borrowing, aimed at pursuing particular economic goals. The main instrument of fiscal policy is the budget, and the main policy variables are government spending and taxation. In our goods market model government spending and taxation are regarded as autonomous variables that influence the demand for goods and the level of production and income on the goods market. We consider the impact of an expansionary fiscal policy and a contractionary fiscal policy respectively, in that order. Screen 3 An expansionary fiscal policy is used to stimulate or expand economic activity by increasing the demand for goods. For fiscal policy to be expansionary it must increase the demand for goods which then increases production and income. This can be achieved by increasing government spending and/or by reducing taxation. We first consider the impact of increased government spending. An increase in government spending implies that government buys more goods from firms in the economy, for instance more text books for schools, medicines for hospitals, cement for buildings, etc. Firms respond by increasing their production of goods and services, to which end they employ more factors of production and households income increases, with the result that they increase their consumption spending, thus increasing demand further, which stimulates the production of goods and services so that households income increases further. The multiplier process is in operation and the increase in government spending stimulates production and income in the economy.

2 Using a chain of events the impact of an increase in government spending can be describe as follows: An increase in government spending G increases the demand for goods Z since it is a component of demand, which causes increased production and income since demand determines output and income. Higher income increases households consumption spending since consumption spending is positively correlated with income. The increase in consumption spending causes a further increase in the demand for goods. The multiplier process is in operation. In our goods market diagram the impact of an increase in government spending is presented as follows:

3 An increase in government spending increases autonomous government spending and the vertical intercept increases with an amount equal to the increase in government spending and the demand for goods curve shifts upwards. At the original level of production and income Ye excess demand develops on the goods market. Producers respond to this excess demand by increasing production and consequently households income also increases. The higher income stimulates consumption spending so that the demand for goods increases and stimulates further production, income and the demand for goods. The process continues until equilibrium is restored at point E 1 with a higher equilibrium income of Y 1. The increase in autonomous government spending has a multiplier effect on the level of production and income in the economy. Let s see what happens when income taxes decline. Screen 4 Lower taxation implies that households disposable income increases and therefore stimulates their consumption spending and the demand for goods. Firms respond by raising production levels with the result that households income increases to cause another round of increases in disposable income, consumption, demand and production. The multiplier process is in operation.

In terms of an events chain the impact of lower taxation can be described as follows: Lower taxation increases disposable income and stimulates households consumption spending and therefore the

4 In terms of an events chain the impact of lower taxation can be described as follows: Lower taxation increases disposable income and stimulates households consumption spending and therefore the demand for goods. Firms respond by increasing production and consequently income increases which generates another round of increased disposable income, consumption and the demand for goods. The multiplier process is in operation. The impact of lower taxation is reflected by the goods market diagram as follows:

Lower taxation increases autonomous spending and the vertical intercept increases equal to the marginal propensity to consume times the decrease in taxation and the demand for goods curve shifts

5 Lower taxation increases autonomous spending and the vertical intercept increases equal to the marginal propensity to consume times the decrease in taxation and the demand for goods curve shifts upwards. The shift in the vertical intercept does not reflect the full extent of the decrease in taxation. Households increase their spending as their disposable income increase but not by as much as the increase in disposable income. At the original level of production and income Y e excess demand develops on the goods market which stimulates production and therefore causes a further increase in household income, which causes a further increase in consumption spending and a further increase in the demand for goods, which again increases production, income and the demand for goods. The process continues until a new equilibrium is reached at point E 1 where a higher equilibrium income of Y 1 is attained. Thus lower taxation has a multiplier effect on production and income. From the above analysis it is clear that an expansionary fiscal policy pursued by increasing government spending and reducing taxation can be used to increase the demand for goods and level of production and income in the economy and thereby reducing unemployment since higher production absorbs more labour. Screen 5 A contractionary fiscal policy is used to cool down economic activity. For fiscal policy to be contractionary it must decrease the demand for goods which lowers production and

income. This can be achieved by reducing government spending and/or by increasing taxation. We first consider the impact of a lower government spending.

6 income. This can be achieved by reducing government spending and/or by increasing taxation. We first consider the impact of a lower government spending. Government spending is reduced by buying less goods from firms in the economy. Firms respond by curbing production. As they decrease their production of goods they employ less factors of production and the income of households decrease. Households respond to this decrease in income by decreasing their consumption spending. Lower consumption spending implies a further decrease in the demand for goods and producers react to this lower demand by producing less goods and services and income of households decreases further. The multiplier process, compared to an increase in government spending is now in the opposite direction, and the decrease in government spending has a contractionary impact on the level production and income in the economy. Using a chain of events the impact of a decrease in government spending can be describe as follows: A decrease in government spending G (a) decreases the demand for goods Z, since government spending is a component of the demand for goods. A decrease in the demand for goods decreases the level of production and income, since the demand for goods determines the level of output and income. A decrease in the level of income decreases consumption spending by households since consumption spending is a positive function of the level of income. The decrease in consumption spending causes a further

7 decrease in the demand for goods. The multiplier process is in operation but in an opposite direction compared to an increase in government spending. The impact of lower government spending is reflected as follows by the goods market model: A lower government spending decreases autonomous government spending and the vertical intercept decreases to reflect an amount equal to the decrease in government spending, and the demand for goods curve shifts downwards. At the original level of production and income Ye an excess supply develops on the goods market. Producers respond by decreasing production and consequently households income decreases as well. The decrease in income reduces consumption spending and a further decrease in the demand for goods which again decreases production, income and the demand for goods. The process continues until a new equilibrium is reached at point E 2 with a lower equilibrium income of Y 2. The decrease in autonomous government spending has a multiplier effect on the level of production and income in the economy. Let s see what happens if taxes increase.

8 Screen 6 Higher income taxes decrease households disposable income with the result that consumption spending and therefore the demand for goods decreases. Firms respond by reducing their production which further reduces households income which causes another round of decreases in consumption, demand and production. The multiplier process is in the opposite direction compared to a decrease in taxation. In terms of an events chain the impact to an increase in taxation can be described as follows: Higher income taxes reduce disposable income and therefore decrease consumption spending and the demand for goods. Firms respond by decreasing their production and thus reducing income. The decrease in income further decreases disposable income, consumption spending and the demand for goods. The multiplier process is in operation.

9 The goods market diagram shows that higher taxation reduces autonomous spending so that the vertical intercept decreases by an amount equal to the marginal propensity to consume times the increase in taxation, and the demand for goods curve shifts downwards. The reason why the decrease in the vertical intercept is less than the decrease in taxation is because households spend less as their disposable income declines but to a lesser extent than their decrease in disposable income. At the original level of production and income Ye an excess supply develops on the goods market. Producers respond by decreasing production and consequently households income declines again. The decrease in income causes a further decrease in consumption spending and a further decrease in the demand for goods which again decreases production, income and the demand for goods. The process continues until a new equilibrium is reached at point E 2 with a lower equilibrium income of Y 2. The increase in taxation has a multiplier effect on production and income. From the above analysis it is clear that a contractionary fiscal policy pursued by decreasing government spending and increasing taxation can be used to reduce the demand for goods and the level of production and income in the economy. This will have the effect of increasing the level of unemployment. Screen 7

10 In this part we compare an increase in government spending with an increase in taxation. An increase in government spending increases the demand for goods while an increase in taxation decreases the demand for goods There is an important difference, however, in the way it influences the demand for goods. While government spending directly influences the demand for goods since it is a component of the demand for goods, taxation indirectly influences the demand for goods through the impact it has on disposable income. This difference is the reason why an equal increase in government spending and taxation still has a stimulatory or expansionary effect on the demand for goods, and on the level of income and output. To explain this we will use an example where it is assumed that government spending and taxation both increase by 100 and a marginal propensity to consume of 0.8, which gives us a multiplier of 5. In the case of government spending the initial increase in autonomous spending is 100 and the vertical intercept increases with 100. The multiplier process proceeds from this increase of 100 and eventually causes the equilibrium level of income to increase by 500. If taxes rises by 100 disposable income decreases by 100 and causes a decrease in consumption spending of 0.8 times 100 which is 80. The reason for the decline of 80

11 instead of 100 is that households do not decrease their spending by the same amount as the decrease in disposable income but at a fraction of the decrease as determined by the marginal propensity to consume. In the diagram the vertical intercept falls by 80 and the equilibrium level of income eventually decreases 5 times 80 which is 400. The final result is that the equilibrium level of output and income increases by 100 and an equal increase in government spending and taxation still has a stimulatory impact on the equilibrium level of output. Screen 8 Given a goods market in an equilibrium at a position of less than full employment it can be brought to full employment by using fiscal policy. At point E 1 the goods market is in equilibrium at an output level of Y 1 which is below full employment Y F and there is unemployment in the economy. Some action is needed since there are no forces present in this model to ensure that full employment is reached automatically. The action can take the form of an expansionary fiscal policy that entails higher government spending and/or reduced taxes to increase the demand for goods causing an increase in the level of production and income.

12 In the diagram the demand curve shifts upwards and the multiplier effect induces higher levels of production and income. Note that due to the multiplier effect the increase in autonomous spending needed to ensure full employment is less than the amount reflected by the gap between Y1 and Y F.

Fiscal policy in the AS-AD model. Screen 1

Fiscal policy in the AS-AD model Screen 1 In this presentation we look at the impact of fiscal policy in the short and medium run as reflected by AS-AD model. Make sure that you are familiar with the following: