determination of national income and the role of fiscal policy

Determination of National Income and the Role of

Fiscal Policy

Determination of National Income and the Role of

Fiscal Policy

Equilibrium Level of National IncomeEquilibrium Level of National Income

• The circular flow of income• The circular flow of income

A simplified circular flow of income modelA simplified circular flow of income model

Cd


CdIncomes


Cd

W = S + T + M

Incomes


Cd

W = S + T + M

J = I + G + X

Incomes


• Effect on national income of a change in injections and/or withdrawals

– J > W : national income rises

– W > J : national income falls

• The Keynesian diagram: the withdrawals and injections approach

– the withdrawals curve

• Effect on national income of a change in injections and/or withdrawals

– J > W : national income rises


• The Keynesian diagram: the withdrawals and injections approach

– the withdrawals curve


OY

W

Cd, W, JDeriving equilibrium national incomeDeriving equilibrium national income

• Effect on national income of a change in injections and/or withdrawals– J > W : national income rises


• The Keynesian diagram: the withdrawals and injections approach– the withdrawals curve

– the injections curve






OY

W

Cd, W, J

J

Deriving equilibrium national incomeDeriving equilibrium national income





– equilibrium





– equilibrium


OY

W

Cd, W, J

J

Y1

b

a


OY

W

Cd, W, J

J

Y2

d

c


OY

W

Cd, W, J

J

Ye

x


• The Keynesian diagram: the income and expenditure approach– the 45° line



OY

Y = Cd + W

W

Cd, W, J

J



– the expenditure curve




OY

W

Cd, W, J

J

Cd

Y = Cd + WE = Cd + J

J




– equilibrium



– equilibrium


OY

W

Cd, W, J

J

Cd


Y1

f

e


OY

W

Cd, W, J

J

Cd


Y2

h

g


OY

W

Cd, W, J

J

Cd


Ye

x

z


The MultiplierThe Multiplier

• The multiplier: introduction

– the circular flow of income and effects of changes in injections

– definition of the multiplier: ΔY/ΔJ

• The withdrawals and injections approach

– graphical analysis: shift in the J line

• The multiplier: introduction

– the circular flow of income and effects of changes in injections


• The withdrawals and injections approach

– graphical analysis: shift in the J line

The multiplier: (a) a shift in injectionsThe multiplier: (a) a shift in injections

OY

W

W, J

J1

Ye1

a

OY

W

J1

J2

Ye1

a

Ye2

b

W, JThe multiplier: (a) a shift in injectionsThe multiplier: (a) a shift in injections

OY

W

J1

J2

Ye1

a

Ye2

b

Y

c

WJJ1

J2

Multiplier = Y / J

= Y / W= ca / bc



• The multiplier: introduction– the circular flow of income and effects of

changes in injections


• The withdrawals and injections approach– graphical analysis: shift in the J line

– the formula : 1/mpw

– or : 1/(1–mpcd)






– or : 1/(1–mpcd)

OY

W

J1

J2

Ye1

a

Ye2

b

Y

c

WJJ1

J2

Multiplier = Y / J= Y / W= ca / bc

= 1/mpw








– or : 1/(1–mpcd)

– graphical analysis: shift in the W line






– or : 1/(1–mpcd)

– graphical analysis: shift in the W line

The multiplier: (b) a shift in withdrawalsThe multiplier: (b) a shift in withdrawals

OY

W1

J

Ye1

a

W, J

OY

W1

J

Ye1

a

W, J

W2

Ye2

c


OY

W1

J

Ye1

a

W, J

W2

Ye2

c

Y

W b

Multiplier = Y / W= ca / ab




changes in injections– definition of the multiplier: ΔY/ΔJ

• The withdrawals and injections approach– graphical analysis: shift in the J line– the formula : 1/mpw– or : 1/(1–mpcd)– graphical analysis: shift in the W line

• The income and expenditure approach




• The income and expenditure approach





• The income and expenditure approach– graphical analysis: shift in the E line




• The income and expenditure approach– graphical analysis: shift in the E line

The multiplier: (c) a shift in the expenditure curveThe multiplier: (c) a shift in the expenditure curve

OY

E, W, J

Y

E1

Ye1

OY

Y

E1

Ye1

E2

Ye2

E, W, JThe multiplier: (c) a shift in the expenditure curveThe multiplier: (c) a shift in the expenditure curve

OY

Y

E1

Ye1

E2

Ye2

Multiplier = Y / J= ca / ba

a

c

Y

J

E, W, J

b

The multiplier: (c) a shift in the expenditure curveThe multiplier: (c) a shift in the expenditure curve

• 'Full-employment' national income

• 'Gap' analysis– the deflationary gap



Keynesian Analysis of Unemployment and InflationKeynesian Analysis of Unemployment and Inflation

OY

W

W, J

J

Ye

The deflationary gapThe deflationary gap

OY

W

W, J

J

YeYF

Deflationary gap

c

d


OY

W, J, E

YeYF

Y

E


OYYe

YF

Y

Ea

b

Deflationary gap

W, J, EThe deflationary gapThe deflationary gap

OY

W

J

YeYF

c

d

Y

Ea

b

Deflationary gap

W, J, EThe deflationary gapThe deflationary gap



– the inflationary gap





OY

W

W, J

Ye

J

The inflationary gapThe inflationary gap

OY

W

W, J

YeYF

J


OY

W

W, J

YeYF

Inflationary gap

Jg

h


OY

YE

W, J, E

Ye


OYYF

YE

Inflationary gap

W, J, E

e

f

Ye


OYYe

YF

YE

Inflationary gap

e

f

W

Jg

h

W, J, EThe inflationary gapThe inflationary gap




– policy implications










• Inflation and unemployment together





• Inflation and unemployment together






• Inflation and unemployment together– inflationary pressures before the full-

employment level of income














– implications for shape of AS curve









OY

Pri

ce le

vel

YF

AS1

Unemployment and inflationUnemployment and inflation

OY

AS1

Pri

ce le

vel

YF

AS2

Unemployment and inflationUnemployment and inflation








– effect of an increase in aggregate demand








– effect of an increase in aggregate demand


O

Pric

e le

vel

National output

YP

The effects of increases in aggregate demandon national output


AS

O Y1

Pric

e le

vel

National output

Y2

AS

Y3 Y4 YP

AD3AD2AD1

AD4



• The Phillips curve– the shape of the curve

• The Phillips curve– the shape of the curve


0

1

2

3

4

5

6

7

8

9

0 1 2 3 4 5 6

The original Phillips curveThe original Phillips curve

Unemployment (%)

Wa

ge in

flatio

n (

%)

• The Phillips curve

– the shape of the curve

– the position of the curve





0

1

2

3

4

5

6

7

8

9

0 1 2 3 4 5 6

The original Phillips curveThe original Phillips curve

Unemployment (%)

Wa

ge in

flatio

n (

%)




– policy implications of the curve










– the breakdown of the curve












– recent relationship between inflation and unemployment






– recent relationship between inflation and unemployment


Inflation (%)

Unemployment (%)

The breakdown of the Phillips curve?The breakdown of the Phillips curve?

6763

6265

6664

60

61

0

2

4

6

8

10

12

14

16

18

20

22

24

26

0 1 2 3 4 5 6 7 8 9 10 11 12 13

Inflation (%)

Unemployment (%)


6763

6265

6664

60

61

0

2

4

6

8

10

12

14

16

18

20

22

24

26

0 1 2 3 4 5 6 7 8 9 10 11 12 13

Original Phillips curve

74

7173

7072

Inflation (%)

Unemployment (%)


6968

6763

6265

6664

60

61

0

2

4

6

8

10

12

14

16

18

20

22

24

26

0 1 2 3 4 5 6 7 8 9 10 11 12 13

75

74

76

77

79

7173

7072

78

Inflation (%)

Unemployment (%)


6968

6763

6265

6664

60

61

0

2

4

6

8

10

12

14

16

18

20

22

24

26

0 1 2 3 4 5 6 7 8 9 10 11 12 13

0

2

4

6

8

10

12

14

16

18

20

22

24

26

0 1 2 3 4 5 6 7 8 9 10 11 12 13

75

74

8076

77

79

7173

7072

78 82

8384

85

81

Inflation (%)

Unemployment (%)


6968

6763

6265

6664

60

61

75

74

8076

77

79

7173

7072

78

90

89

9188

95

82

8384

85

86

93

8792

94

81

Inflation (%)

Unemployment (%)


6968

6763

6265

6664

60

61

0

2

4

6

8

10

12

14

16

18

20

22

24

26

0 1 2 3 4 5 6 7 8 9 10 11 12 13

0

2

4

6

8

10

12

14

16

18

20

22

24

26

0 1 2 3 4 5 6 7 8 9 10 11 12 13

75

74

8076

77

79

7173

7072

78

90

89

9796

9188

95

82

8384

85

86

93

8792

94

81

Inflation (%)

Unemployment (%)


6968

6763

6265

6664

60

6199

9800

01

03

02

Keynesian Analysis of the Business CycleKeynesian Analysis of the Business Cycle

• The accelerator

– changes in national income and induced investment

– the accelerator effect

• The accelerator



The accelerator effectThe accelerator effect

• The accelerator



– the instability of investment

• The accelerator





-10

-8

-6

-4

-2

0

2

4

6

8

10

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

%(a) EU-15 Growth in GDP and business Investment(a) EU-15 Growth in GDP and business Investment

GDP growth (%)

-10

-8

-6

-4

-2

0

2

4

6

8

10

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

%(a) EU-15 Growth in GDP and business Investment(a) EU-15 Growth in GDP and business Investment

GDP growth (%)

Business investment(% change)

(b) EU-15 Industry confidence indicator

-30

-25

-20

-15

-10

-5

0

5

10

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

• The accelerator




• The multiplier/accelerator interaction

• The accelerator






• The accelerator





• Fluctuations in stocks

• The accelerator





• Fluctuations in stocks


• Determinants of the course of the business cycle– why do booms and recessions persist?

• time lags

• 'bandwagon' effects

– why do booms and recessions end?• ceilings and floors

• echo effects

• the accelerator

• random shocks

• changes in government policy

• Determinants of the course of the business cycle– why do booms and recessions persist?

• time lags

• 'bandwagon' effects

– why do booms and recessions end?• ceilings and floors

• echo effects

• the accelerator

• random shocks

• changes in government policy


The Role of Fiscal PolicyThe Role of Fiscal Policy

• The purpose of fiscal policy

– correcting a fundamental disequilibrium

– fine tuning

• Deficits and surpluses

– central government deficits and surpluses

– public-sector deficits and surpluses

– the PSNCR

– the national debt

• The purpose of fiscal policy

– correcting a fundamental disequilibrium

– fine tuning

• Deficits and surpluses

– central government deficits and surpluses

– public-sector deficits and surpluses

– the PSNCR

– the national debt

UK public-sector borrowingUK public-sector borrowing

Source: www.statistics.gov.uk (National Statistics): Series RURQ and YBHA

General government deficits/surplusesand debt as % of GDP

General government deficits/surplusesand debt as % of GDP

The Role of Fiscal PolicyThe Role of Fiscal Policy

• The use of fiscal policy

– automatic fiscal stabilisers

– discretionary fiscal policy

• The use of fiscal policy

– automatic fiscal stabilisers

– discretionary fiscal policy

Effectiveness of Fiscal PolicyEffectiveness of Fiscal Policy

• Factors determining the effectiveness of fiscal policy

– accuracy of forecasting

– effect on J and W

– effect of changes in J and W on national income

– timing of the effects

– effects on the various macro objectives

• Factors determining the effectiveness of fiscal policy

– accuracy of forecasting

– effect on J and W

– effect of changes in J and W on national income

– timing of the effects

– effects on the various macro objectives


• Discretionary policy– problems of forecasting the magnitude of

the effects• effects of changes in government expenditure

• crowding out

• effects of changes in taxes

• size of the multiplier and accelerator effects

• random shocks

– problems of timing and time lags• various time lags

• policy may be destabilising

• Discretionary policy– problems of forecasting the magnitude of

the effects• effects of changes in government expenditure

• crowding out

• effects of changes in taxes

• size of the multiplier and accelerator effects

• random shocks

– problems of timing and time lags• various time lags

• policy may be destabilising

Fiscal policy: stabilising or destabilising?Fiscal policy: stabilising or destabilising?

O

Rea

l nat

iona

l inc

ome

Time

1

2

3

4

1

2

3

4

Path (a): no intervention

O

Rea

l nat

iona

l inc

ome

Time

1

2

3

4

1

2

3

4


Path (b): policy stabilises


O

Rea

l nat

iona

l inc

ome

Time

1

2

3

4

1

2

3

4


Path (c): policy destabilisesPath (b): policy stabilises



• Side-effects of discretionary policy

– cost inflation

– welfare and distributive justice

– incentives

• A rules-based approach to fiscal policy

– a 'steady-as-you-go' policy

– the EU Stability and Growth Pact


– cost inflation


– incentives




Getting budget deficits downGetting budget deficits down

-3

-1

1

3

5

7

9

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001Bud

get d

efic

its a

s a

% o

f GD

P


France

-3

-1

1

3

5

7

9

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001Bud

get d

efic

its a

s a

% o

f GD

P


FranceGermany

-3

-1

1

3

5

7

9

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001Bud

get d

efic

its a

s a

% o

f GD

P


FranceGermany

Italy

-3

-1

1

3

5

7

9

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001Bud

get d

efic

its a

s a

% o

f GD

P


Spain

FranceGermany

Italy

-3

-1

1

3

5

7

9

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001Bud

get d

efic

its a

s a

% o

f GD

P


Spain

FranceGermany

Italy

Belgium

-3

-1

1

3

5

7

9

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001Bud

get d

efic

its a

s a

% o

f GD

P


Spain

FranceGermany

Italy

Netherlands

Belgium

-3

-1

1

3

5

7

9

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001Bud

get d

efic

its a

s a

% o

f GD

P



– cost inflation


– incentives




– UK Labour government's 'Golden Rule'


– cost inflation


– incentives




– UK Labour government's 'Golden Rule'

determination of national income and the role of fiscal policy

Documents

j line w

cd w e

mpcd w

cd j cd e f w jo y1

cd j g h cd w jo y2

equilibrium national

injections curve cd

cd j cd z w x jy o ye