EC 102.01

Midterm 2 – July 21, Thursday 13:00 – 15:00 Exactly at class time, venue: Hisar CampusHKD 201 : ACAR – ISIKHKD 101 : INAM – YILDIZ

Ch 9, Ch 10, Ch 11 (Sections 1,2,3,4 (except 4.4), 5) + if time permits Ch 12 (Section 1)

Outline

Macroeconomic Theory and PolicyChapter 9 – Aggregate Demand and Economic

FluctuationsSection 3 – Keynesian Model – Multiplier

Chapter 10 – Fiscal PolicySection 1 – Role of Government Spending and TaxesSection 2 – Budgets, Deficits and Policy Issues

Output (Y* )

Income (Y* )

Insufficient Spending

AD < Y*

Production generates income

Income goes to households

If leakages are larger than injections…

Lower Income

Lower Spending

AD = lower YLower Output

Keynesian Model of AD

Keynesian Model - The Multiplier at WorkChange in Intended

Investment

Change in Aggregate Demand(as C or II change)

and in Output and Income(as firms respond to changes in AD)

Change in ConsumptionΔC = mpc Δ Y

= .8 Column (2)

1. Investors lose confidence.Δ II = 80

2. Reduced investment spending leads directly to Δ AD = 80.Producers respond to reduced demand for their goods by cutting back on production.Δ Y = 80

3. Less production means less income. With income reduced by 80, households cut consumptionby mpc Δ Y= .8 80ΔC = 64

4. Lowered consumption spending means lowered ADΔ AD = 64Producers respond.Δ Y = 64

5. Households cut consumptionby mpc Δ Y= .8 64ΔC = 51.2

6. Δ Y = 51.2 7. mpc Δ Y = .8 51.2ΔC = 40.96

8. Δ Y = 40.96 9. ΔC = 32.77

10. Δ Y = 32.77 11. ΔC = 26.21

etc. etc.

Sum of changes in Y= 80 + 64 + 51.2 + 40.96 + 32.77 +. . . .= 400

Fiscal PolicyFiscal policy - government spending and taxation

policiesAdding up the government sector to the Keynesian

modelAD = C + II + G

G: government spendingE.g. construction of new roads by the government

– government money spent on goods and payments to workers: creating new AD, multiplier effect adding to the original stimulus by G

Fiscal Policy

An Increase in Government Spending

(1) Income

(Y)

(2) Consumption

(C)

(3) Intended

Investment (II)

(4) Original

Aggregate Demand

(AD = C + II)

(5) Government

Spending (G)

(6) New Aggregate

Demand (AD1 = C + II + G)

300 260 60 320 80 400 400 340 60 400 80 480 500 420 60 480 80 560 600 500 60 560 80 640 700 580 60 640 80 720 800 660 60 720 80 800

An increase in government spending has a similar effect to an increase in intended investment. The end result is increases in the equilibrium levels of income and output.

Agg

rega

te d

eman

d an

d ou

tput

800

400

160

80

0

AD1 (G=80)

AD0 (G=0)

45°

E1

E0

400Y*

Income (Y)800

Unemployment equilibrium

Full employment equilibrium

Full employmentFiscal Policy

Fiscal PolicyGovernment spending is one way of increasing

GDP.Other options: cutting taxes and/or increasing

transfer paymentsTransfer payments: government grants, subsidies,

social security/social assistance/unemployment compensation payments to individuals, interest payments to holders of government bonds

Mostly used fiscal tool: tax reductions – politically popular

Fiscal PolicyQ: How do the changes in taxes and transfer

payments affect equilibrium level of output and income?

not similar to the changes in G!G – directly affects AD and GDPT – indirectly affect AD and GDP (through C or II)Depends on the type of tax and transfer payment

introduced or altered.Focus on effects of changes in income taxes and

transfers to individuals.

Fiscal PolicyE.g. assume tax cut of 50 – not fully reflected in

increasing spending by 50 but rather works through “marginal propensity to consume”!mpc * amount of tax cut = change in consumption

E.g. assume transfer payment of 50 – same mechanism!

mpc * amount of transfer = change in consumptionDisposable income – income available to consumers

after paying taxes and receiving transfersYd = Y – T + TR

Fiscal PolicyLump-sum taxes : fixed at a level irrespective of the

income levelTax multiplier -> impact of a change in a lump sum

tax on equilibrium level of income/output.Works in two stages: (i) consumption is reduced by

mpc * change in lump sum tax(ii) The reduction in consumption has multiplier

effect on equilibrium incomemultiplier * (mpc * change in lump sum tax)

Fiscal PolicyTax increase – reduces Yd; contractionary effectTax cut – increases Yd; expansionary effectTransfer payments – some sort of negative tax;

works in the same logic as tax cuts.In reality – income taxes are generally proportional

or progressive (i.e. increase with income levels)Effect on AD – flattening AD curve because higher

impact on high levels of incomeBalanced budget – governments may intend to

offset the effect of increase in G by increase in T

Fiscal PolicyExpansionary Fiscal Policy – use of government

spending, transfer payments or tax cuts to stimulate higher levels of economic activityincrease G, increase TR, decrease T

How to finance?? borrowing or increased taxation. Second option is likely to offset the impact

Too much spending may have inflationary effect – increase in G may overshoot the FE level of output, excess demand -> “overheating”

Fiscal PolicyContractionary Fiscal Policy – reductions in

government spending, transfer payments or tax cuts leading to lower levels of economic activitylower G, lower TR, increase T

Could be regarded as a cure for inflation to overcome the excessive aggregate demand.

Unwise to use at times of unemployment – may lead to further stagnation by overshooting in the downward direction!

Budgets, Deficits and Policy IssuesFiscal policy - government spending and taxationGovernment expenditures = government outlays

G + TRBudget => revenues and expendituresRevenue side = taxes (T)When revenues are not sufficient to cover

expenditures => borrowingInternal borrowing: sale of government bonds or

treasury bills to the public, interest-bearing securities with a promise to pay in future

Budgets, Deficits and Policy IssuesRevenues, 2009 Expenditures, 2009

Balance = deficit (revenues fall short of expenditures)

Budgets, Deficits and Policy IssuesBudget Balance = Surplus (+) /Deficit (-) = T – (G+TR)Generally shown as a % of GDP - larger the economy,

easier to handle a given deficit as the fiscal impacts of the deficit would be relatively small

Budgets, Deficits and Policy IssuesDeficit vs. Debt? Deficit is a flow variable for the

current period but debt is a stock variable hich shows accumulated deficits over the years!

Debt increases when there is deficit !Commonly held view: “Debt as a burden on future generations” ??

Budgets, Deficits and Policy IssuesMost of the goverment debt is domestically owed –

domestic citizens are holding government bonds, treasury bills etc. which are indeed “assets”.

Debt does not necessarily have to be paid off immediately – “rolling over”: replacing it by another debt => possible as long as government is credible

Easier to roll over when denominated in domestic currency

Budgets, Deficits and Policy IssuesBUT still problematic to have debt- interest must be paid on the debt:

intergenerational inequalities as a burden on future taxpayers

- increasing proportion of debt has to be paid in FXNeed for management of debt if cannot avoid

having it: e.g.productive investments versus unwise defense expenditures – need for a careful cost-benefit analysis for debt and pursue spending and tax policies accordingly.

Budgets, Deficits and Policy IssuesKeynesian idea: Government spending is an

important part of the economic policies to prevent recession.

Recently – controversies over use of fiscal policies especially in relation to the impacts on inflation and deficits

Evidence shows that government budget moderates fluctuations in AD without any other intervention

Automatic stabilizers – tax and spending institutions tend to increase government revenues and lower expenditures during expansions and vice versa during recessionary periods.

Budgets, Deficits and Policy IssuesAutomatic stabilization but HOW?Suppose there is recession => AD falls, government

deficit increases as tax revenues are decreasing due to declining incomes and expenditures increase as there is more receipt of welfare payments (unemployment benefit etc.), decline in C is prevented, therefore recession is moderated.

Suppose there is expansion => tax revenues increase as incomes increase, expenditures fall as fewer people receive welfare benefits, disposable income does not rise as fast as national income, C slows down, limiting inflationary overheating