Keynesian Expansionary Fiscal Policy

and the Impact on the Government Budget

Keynesian Expansionary Fiscal Policy

• Given the results of the General Theory, fiscal and monetary policies were developed that could be used to fight unemployment and recession or inflation.

Fiscal and Monetary Policy

• Fiscal policy is the attempt to affect macroeconomic variables such as aggregate output and employment and the price level through government spending and tax policies.

• Monetary policy is the attempt to affect those same macro variables through interest rate and money supply policies.

Keynesian Expansionary and Anti-Inflationary policies.

• Expansionary policy is the use of government fiscal and monetary policies to cure recession and unemployment.

• Anti-Inflationary policy is the use of fiscal and monetary policies to fight inflation.

Keynesian ExpansionaryFiscal Policy

• Suppose the economy is in an economic downturn, stuck in an unemployment equilibrium of $1600, when the full employment capacity of the economy is $2000, and the society-wide average marginal propensity to consume is .75. Thus:

Yf = $2000 Ye = $1600 mpc = .75

Yf = $2000 Ye = $1600 mpc = .75

• Identify three types of fiscal policies to bring the economy to full employment and cite the impact on the government budget deficit (or surplus) in each case.

calculate the size of the gap

• First we must calculate the recessionary gap in this economy. To do that, we first calculate the value of the multiplier. The multiplier is 1/(1-b) = 1/(1-.75) = 1/.25 = 4. Now we can calculate the gap as:

(Yf – Ye)/multiplier = (2000-1600)/4

= 400/4 = 100.

Government Spending

• 1. The first fiscal policy that may be used is to increase government spending, or G, by the size of the recessionary gap, holding taxes constant.

Government spending and the multiplier

• Since the gap is 100, we increase G by 100. This autonomous spending will have a multiplier effect of 4, so 100 x 4 = 400 in total increased aggregate output and income, moving the economy from the original equilibrium of Ye = 1600 to the full employment level of Yf = 2000.

Effect of increasing G (holding taxes constant) on the government

budget• Since we increased G by the size of the

gap, or 100, and held taxes constant, the deficit will rise (or surplus fall) by the size of the gap, in this case 100.

Recall that:

G > T budget deficit

G < T budget surplus

G = T balanced budget

cutting taxes

2. The second fiscal policy that may be used to close the gap is to cut taxes (T), holding government spending G constant.

• Cutting taxes (T) will increase disposable income (Yd), which will stimulate consumption (C), with multiplier effects & expanding output and employment (Y).

How much should taxes be cut?

• It might be thought that since the amount government spending is increased to close the gap is the size of the gap, that the amount that taxes need to be cut is also the size of the gap, in this case 100.

cutting taxes to expand the economy

• If T is cut by the size of the gap, 100, Yd increases by the size of the gap, 100, and C increases by mpc x the size of the gap = .75 x 100 = 75. This has a multiplier effect of 4, 4 x 75 = 300 and output increases from Ye1 = 1600 Ye2 = 1900. We didn’t make it to Yf, why?

cutting taxes to expand the economy

• If T is cut by the size of the gap, 100, Yd increases by the size of the gap, 100, and C increases by mpc x the size of the gap = .75 x 100 = 75. This has a multiplier effect of 4, 4 x 75 = 300 and output increases from Ye1 = 1600 Ye2 = 1900. We didn’t make it to Yf, why? Because some of the increased Yd resulting from the tax cut is saved, according to the mps, .25.

formula for tax cuts

• So we need to cut taxes in such a way that consumption will go up by the size of the gap. So the question is:

gap = mpc x ? (? = how much taxes need to be cut to get the necessary stimulus, taking savings into consideration.)

rearranging, we get:

? = gap/mpc

tax cut formula

• So, the general formula for finding out how much to cut taxes to get the same stimulus we would get by increasing G is to cut taxes by gap/mpc. In this case, that would mean 100/.75 = 133.33.

tax cut stimulus

• So we cut taxes by 133.33, then Yd rises by 133.33 and C rises by .75 x 133.33 = 100. This increased consumption spending will have a multiplier effect of 4, so 100 x 4 = 400, moving the economy from 1600 2000, or from Ye to Yf.

Effect of tax cut on budget

• But in this case, the tax cut holding G constant will result in an increased deficit (or decreased surplus) of gap/mpc, in this case $133.33, rather than the size of the gap, $100, as in the case of government spending. So, it takes a larger deficit to get the same stimulus with a tax cut than it would with increased government spending.

Balanced Budget Multiplier (BBM)

3. The third fiscal policy that can be used to close the gap is to use the balanced budget multiplier. The balanced budget multiplier allows us to close the gap without an increased deficit or decreased surplus.

BBM

• Thus G is increased by Yf – Ye, but that spending increase is offset by an increase in taxes of the same amount. So we increase both G and T by Yf – Ye.

BBM

• In this case, Yf – Ye = 400, so G and T are increased by 400. (This is also due to the BBM always being equal to one.)

BBM

• If we increase G by 400, it will have a multiplier effect of 4, so 4 x 400 = 1600 (+)

We offset this with an increase in T

by 400. This decreases Yd by 400,

so C decreases by .75 x 400 = 300.

This spending decrease has a negative

Multiplier effect of 4, so 4 x 300 = 1200 = 1200 (-)

BBM

1600(+) and 1200(-) means a total net effect of 400(+), and the economy moves

from 1600 2000, or from Ye to Yf.

alternative calculation

Another way to calculate it would be to take the increase of G by 400 =

400(+)

The increase of T by 400 means

a decrease of Yd by 400 means a

Decrease of C by 300 =300(-)

BBM

• 400(+) and 300(-) means an initial net effect of 100(+). Multiplier effect of 4 means 4 x 100 = 400, and the economy moves from Ye to Yf or from

1600 2000.

BBM

• 400(+) and 300(-) means an initial net effect of 100(+). Multiplier effect of 4 means 4 x 100 = 400, and the economy moves from Ye to Yf or from

1600 2000.

So the multiplier impact can be calculated either before or after calculating the net change (but not both or neither).

BBM –general formula

Finally, we can show the BBM equals one by taking the formula for the multiplier times the mps x the difference between Ye and Yf:1/(1-b) x (1-b) (Yf – Ye)(1-b) is the same thing as (1-b)/1, so:1/(1-b) x (1-b)/1 (Yf – Ye)

so the (1-b)s cancel out and we are left with:(Yf – Ye), in this case = 400.

So increase both G and T by (Yf – Ye), or 400.

policy choices

• With the balanced budget multiplier, there is no change in the deficit or surplus. But note that government spending must be increased by four times the amount that would be necessary if government were willing to run a deficit, and taxes must be increased considerably.

policy choices

• This shows how there are trade-offs in policymaking. What would we rather have, a greater increase in government spending and more taxes with no deficit, or a smaller increase in spending with a deficit, or a tax cut and a larger deficit?

policy choices and policy goals

• But also remember that these are not purely economic issues. There is budgetary politics and there is fiscal politics. These do not always coincide with the economics. As economists, our focus is on the economics. We need to explain to the politicians and policymakers what their choices are and what the expected outcomes will be. Then they will decide.