The McGraw-Hill Companies, 2008 Chapter 21 Fiscal policy and foreign trade David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9th Edition, McGraw-Hill, 2008 PowerPoint presentation by Alex Tackie and Damian Ward The McGraw-Hill Companies, 2008 Some key terms Fiscal policy the governments decisions about spending and taxes Stabilisation policy government actions to try to keep output close to its potential level Budget deficit the excess of government outlays over government receipts National debt the stock of outstanding government debt The McGraw-Hill Companies, 2008 Government in the income-expenditure model Direct taxes affect the slope of the consumption function and hence the slope of the AD schedule. Government expenditure affects the position of the AD schedule. The McGraw-Hill Companies, 2008 Government in the income-expenditure model AD=C+I+G Assume I and G is independent of Y. Transfer payment affects C or I and not included in G. The McGraw-Hill Companies, 2008 Government in the income-expenditure model Transfer payment are added to income and direct taxes are subtracted from it: Net taxes=t*Y-B Disposable income (YD) = (1-t)*Y+B The McGraw-Hill Companies, 2008 Government in the income-expenditure model Lets assume autonomous consumption and transfer payments is 0 and mpc is 0.9 When Y increases by 1, then consumption will increase by 0.9*(1- t). MPC after tax (MPC)=MPC*(1-t). The McGraw-Hill Companies, 2008 Fiscal policy? Income, output Aggregate demand 45 o line AD 0 Y0Y0 But this ignores some important issues prices, interest rates, and the need to fund the government spending. AD 1 This seems to suggest that the government could influence aggregate output in the economy by raising AD from AD 0 to AD 1, Y1Y1 thus raising equilibrium output from Y 0 to Y 1. The McGraw-Hill Companies, 2008 Government Spending in Turkey (2005,2010) (Millions TL) 8 The McGraw-Hill Companies, 2008 The Government Spending in Turkey (%) (2011) The McGraw-Hill Companies, The McGraw-Hill Companies, The McGraw-Hill Companies, The Debt in Turkey (Millions of dolars) ( ) The McGraw-Hill Companies, Kaynak: Hazine Mstearl The McGraw-Hill Companies, Kaynak: Hazine Mstearl The McGraw-Hill Companies, 2008 but in surplus at high levels. then the budget will be in deficit at low levels of income The government budget The budget deficit equals total government spending minus total tax revenue. If government spending is independent of income, G G, NT Income, output The balanced budget multiplier states that an increase in government spending plus an equal increase in taxes leads to higher equilibrium output. Balanced budget but net taxes depend on income, NT Y0Y0 The McGraw-Hill Companies, 2008 Automatic stabilisers mechanisms in the economy that reduce the response of GNP to shocks for example, in a recession: payments of unemployment benefits rise and receipts from VAT and income tax fall The McGraw-Hill Companies, 2008 Limits on active fiscal policy Time lags: it takes time to diagnose the problem to take action for the multiplier process to operate Uncertainty the size of the multiplier is not known aggregate demand is always changing Induced effects on autonomous demand changes in fiscal policy may induce offsetting effects in other components of aggregate demand Why cant shocks to aggregate demand immediately be offset by fiscal policy? The McGraw-Hill Companies, 2008 Limits on active fiscal policy (2) The budget deficit concern about inflation if the budget deficit grows Maybe were at full employment! unemployment may be (at least partly) voluntary Why doesnt the government expand fiscal policy when unemployment is persistently high? The McGraw-Hill Companies, 2008 Foreign trade and income determination Introducing exports (X) & imports (Z) TRADE BALANCE the value of net exports (X - Z) TRADE DEFICIT when imports exceed exports TRADE SURPLUS when exports exceed imports Equilibrium is now where Y = C + I + G + X - Z The McGraw-Hill Companies, 2008 At higher income levels, there is a trade deficit. At relatively low income, exports exceed imports there is a trade surplus. Exports, imports and the trade balance Income X, Z but that imports increase with income. Imports Assume that exports are independent of income, Exports There is trade balance at income Y*, but there is no guarantee that this corresponds to full employment. Y* The McGraw-Hill Companies, 2008 Foreign trade and the multiplier The marginal propensity to import is the fraction of additional income that domestic residents wish to spend on additional imports. The effect of foreign trade is to reduce the size of the multiplier the higher the value of the marginal propensity to import, the lower the value of the multiplier. M=1/[1-(MPC-MPZ)]