Chapter 7:Government Sector

Kornkarun Kungpanidchakul, Ph.D.Macroeconomics

MS FinanceChulalongkorn University, Spring 2008

Fiscal policy

• The policy regarding government expenditure, government revenue, and transfers.

Government budgets

• Budget surplus : The amount by which a government’s revenue exceeds its expenditures. The government can lend the surplus.

• Budget deficit : The amount by which a government’s expenditures exceed its revenue. The government must borrow the shortfall via bonds and we can expect future taxes sufficient to cover the loan repayments.

• Balanced budget : revenue exactly covers its expenditure.

Government Revenue

• The resources for government spending come from:– Selling the output as the owner of a private

business.– Nationalization : take over or nationalize an

industry that has been set up by private owners.

– Print money.– Taxation (the most common method)

Taxation

• Variable tax : a tax in which the amount paid is dependent on the value of some quantity that is within an individual’s control.

• Lump-sum tax : a tax in which the amount paid is not dependent on any variables that are within an individual’s control.

• Head tax: a lump-sum tax in which each person pays the same amount.

• Disincentive effect : the substitution effect that results from taxing consumption or production of a specific good resulting in a decrease in the consumption or production of that good.

Government Spending

• Public goods

• Government consumption

• Temporary spending to stimulate the economy.

• Income distribution, social security

Public goods

• Public goods are a good that tends to be undersupplied in private competitive markets.

• The properties of public goods are nonexcludable and nonrival.

• Nonexcludable means a good that people cannot be excluded from using, e.g. unlocked wireless internet, public restrooms, fish in the ocean, environment.

• Nonrival means a good that unlimited numbers of people can use without interfering with each other’s enjoyment, e.g. fire protection, uncongested toll roads.

Categories of Government Spending

• Productive spending : Government spending with benefits that exceeds its cost. This happens when the government supplies a public good that would be inefficiently supplied by the private sector.

Categories of Government Spending II

• The wasteful government spending is government spending with benefits that are less than its cost. This is the case that the good that the government provides creates the higher cost than when the private sector provides.

Categories of Government Spending III

• Pure transfers (transfer payment) : The benefit of a government spending program just happen to offset the cost. The example of the case that this outcome is expected is a transfer payment. For example, the government taxes Peter $100 in order to make a $100 cash transfer to Paul. No resources are either created or destroyed. There is only a change in the resource distribution.

Fiscal policy for the economic stability

• Keynes suggested that we can use the fiscal policy to sustain the economic stability– Expansionary Fiscal Policy to stimulate the

economic growth when there is economic recession or depression.

– Cotractionary Fiscal policy when the output and the employment level is higher that the full employment/stable level.

Haavelmo Theorem

• Even though the government decides to cover all government spending via an increase in taxes with an equal amount, the balanced budget can still stimulate the total expenditure and the economic growth.

Crowding out effect

• Classical crowding out effect An increase in the government spending will be

substituted with a decrease in the private sector’s spending

i) The government spending will decrease the investment, so as the output in the long run (direct crowding out effect)

ii) Ricardian Equivalence : When the government increases its spending, consumers expect to have higher tax in the future; therefore, consumers decide to increase saving and decrease consumption in this period.

Crowding out effect

• Indirect Crowding Out effect / Keynesian Crowding out – In the extreme Keynesian, there is no crowding out

effect.– In the general Keynesian, the government spending

decreases the supply in the money market since the government has to issue bonds. Therefore, the interest rate increases, so as the cost of investment. Therefore, the government spending has indirect crowding out effect on investment via the higher interest rate.