TUTORIAL 6 (28 APRIL 2 MAY) ANSWER KEY

Fiscal Policy
Textbook Reference: Chapter 6
Main Concepts
Government expenditure
Taxation
Endogenous taxes
Automatic Stabilisers
Balanced budget multiplier
Public Debt
Review Questions
Question 1
This question illustrates the workings of automatic stabilisers. Suppose the components of
planned spending in an economy are

where t is the tax rate. In this economy, the tax system acts as an automatic stabiliser,
because tax revenues automatically decline when national income falls.
(i)
Solve for an equation that determines the short-run equilibrium output for this
economy.
Since imports are zero,

Where [
In equilibrium,

] is exogenous expenditure and [

[

]
[

] is induced expenditure.

]
]

The last line is short-run equilibrium when taxes are endogenous, or proportional to output.

(ii)
Find the expression for the multiplier, i.e. the amount that output changes when
exogenous expenditure changes by one unit.
The multiplier for a change in exogenous government expenditure is:
[

So that for any change in an exogenous variable, for example, a change in government expenditure
, the change in short run equilibrium output
is:
[

(iii)
Compare the formula for the multiplier in (ii) with the case when taxes are
exogenous. Show that making taxes proportional to income (i.e. endogenous) reduces the
size of the multiplier.
When there are only exogenous taxes:
[

So that the multiplier is:

[

It can be shown that:

[
If

(iv)
Explain how reducing the size of the multiplier (or increasing the tax rate t) helps to
stabilise the economy.
Short-run equilibrium output is equal to the multiplier times autonomous expenditure. For any
fluctuation in autonomous expenditure, the smaller the multiplier, the less output would fluctuate. So
changes in the economy that reduce the multiplier tend to stabilise output. For example, according to
empirical evidence, contractions are most often led by a fall in autonomous investment. With a higher
tax rate, the fall in output would be lower than had the tax rate been lower. It has often been said
that this is driven by the fact that the expansions being milder due to the higher tax rate.

(v)
Suppose that c=0.8 and t=0.25, calculate the multiplier.
With income taxes:
[

Without income taxes:

Question 2
(i)
The government is considering two alternative policies, one involving increased
government purchases of $50 billion and the other involving a cut in exogenous taxes of $50
billion. Which policy is likely to increase planned aggregate expenditure by more? Explain.
Use the AE model to illustrate your answer.
The increase in government expenditure raises autonomous (or exogenous) planned aggregate
expenditure by $50 billion. The cut in exogenous taxes raises disposable income by $50 billion, which
also stimulates planned aggregate expenditure by raising consumption spending, but there is also a
leakage via purchases of imports. To see the effects on PAE it is useful to write the equation for the
4-sector model. .
Note that the lecture notes may have a slightly different version of the four sector model to the
textbook:
Equation for PAE in 4-Sector Model

where

and

and

You can see that an increase in G of $50 billion will directly raise PAE by $50 billion. But a tax cut
(exogenous taxes) of $50 billion will raise PAE by the (smaller) amount of $[(c-m)*50] billion.

Thus the increase in government expenditure is predicted to have the greater impact on aggregate
demand.

If:

(ii)
Explain the effect of a cut in the tax rate on an economys planned AE. Is the effect
different from a cut in the exogenous component of taxation?
Note the use of the expression tax rate. This refers to the marginal income tax rate
. As the tax
rate affects the slope of the planned aggregate expenditure line, a decrease in the tax rate is quite
different to a decrease in the exogenous component of taxation. Specifically, a decrease in the tax
rate from t0 to t1 will increase the slope of the planned aggregate expenditure line. An increase in the
exogenous component of taxation will lead to a parallel shift upwards of the planned aggregate
expenditure line. In the diagram below, exogenous expenditure is constant at the value E, and a
decrease in the tax rate increases the slope which gives and initial increase in planned aggregate
expenditure from PAE0 to PAE1. At the level of output Y0, planned aggregate expenditure is greater
than output. This results in an unintended decline in inventories. Firms respond by increasing
production, and output increases inducing even greater expenditure. The economy reaches short run
equilibrium where PAE2 is equal to Y1.

(iii)
Discuss the reasons why, in practice, the use of fiscal policy more complicated than
what is suggested by the AE model?
Fiscal policy is more complicated. Some issues to consider include:

Inflexibility and lags in the implementation of fiscal policy

Persistent budget deficits, crowding-out of private investment and a large public debt

Supply-side effects (on potential output) from fiscal policy

See BOF section 6.3 p174-177.

Discussion Questions
Question 3
The following equation is a version of the government budget constraint from page 185,
Chapter 6) of BOF.
The one change to the equation is that in the above case the real interest rate is not
constant over time.
(i)
What does each variable in above equation denote?
= government purchases, over period
= transfer payments, over period
= interest payments, at interest rate determined in the previous period
, levied on
outstanding debt at end of period
.
= taxes, over period
= new government borrowing, the difference between the outstanding debt stock from the
end of period and the end of period
.

(ii)
Explain in words the implications of the government budget constraint. Does it mean
that a government must balance its budget on a year to year basis? Why not? The
government budget constraint can be used to think about the options by which the Greek
debt crisis might be resolved.
The government budget constraint implies that government expenditure (
) must
be financed either by taxes or by government borrowing. Provided the government can borrow (and
lend) then the budget does not need to be balanced on an annual basis.

(iii)
We can think of the Greek situation as being one in which additional government
borrowing (at least from financial markets) is no longer possible. In terms of the above
equation we have
. If this is the case then what are the only options
available to the Greek government to solve the crisis.
If
the government budget constraint becomes
.
Now the Greek government has to fund its government spending, transfers and interest payments out
of its taxation revenue. Obviously one possibility is that it does not meet interest payments (and any
repayments) and so effectively defaults on its debt.
The other options are to:
- Reduce spending and transfers
- (and/or) raise taxes.

(iv)
In terms of the government budget constraint how does a bailout of Greece by the
other Eurozone countries work?
Another possible option (that is not in the above constraint) is for a Greek bailout by other countries
in the Euro zone. Basically the other countries just make a transfer for Euros to Greece so that it can
meet its debt obligations. Eurozone countries may be obliged to do so for the collective benefit of the
Eurozone.

(v)
Although it is not included in the above equation, BOF (page 185) discuss the option
of governments printing money to finance a budget deficit. Does Greece have this option?
Explain.
If Greece issued its own currency (like Australia) there would be an additional term in the government
budget constraint, which reflects (what is commonly called) printing money. In this case the Greek
government could always pay-off its debts (borrowings) by printing some more of its currency.
However, since Greek debt is denominated in Euros and Greece cannot just print additional Euros at
will, it does not have this option. Of course what Greece could do (and what is roughly equivalent) is
to leave the Euro area and introduce its own currency.