The Keynesian Model (II) and Fiscal Policy

Private savings

Disposable income less consumption

Private savings formula

(Y-T) - C

Investments formula

S + (T-G)

• private savings + public savings

Marginal propensity to save

(1-c)

• tells us how much of each extra dollar of income people save instead of spend

Equilibrium output can also be defined as when

Planned investment = Planned savings

Formula for when I = S (equilibrium)

[1/(1-c)]/(c̄ - cT + I +G)

Paradox of thrift

When everyone in the economy tries to save more money at the same time, total savings in the economy may actually fall because total income and output fall.

Reasoning behind Paradox of Thrift

1. People decide to save more —> spend less

2. Consumption falls —> Aggregate expenditure (AE) falls

3. Firms see less demand —> cut production —> income falls (Y)

4. As Y falls, peoples ability to save also falls

So there is now more saving at any level of Y, but equilibrium level of output is lower

To avoid outcome of Paradox of thrift (Y falling while S increases)

Public dissaving (deficit spending) can usefully offset an increase in private savings.

• Gov can spend more than it collects in taxes G > T injecting more money into the economy, encouraging spending [cut taxes, spend more]

Fiscal Policy

When the government changes its spending (G) and taxation (T) to influence the level of economic activity.

What does it mean by government expenditure?

• gov. purchases of goods/services (schools, police, courts, military, roads]

• transfers to households and firms (age pension, newstart, parental support)

• interest payments to holders of gov. debt

What does it mean by revenue in relation to the government?

personal and company income taxes, GST, land taxes

Side effects of fiscal policy in demand management

• changes in taxes may distort incentives to work and invest

• deficit-fiananced gov. spending may push up interest rates ‘crowding out’ private sector investment

Practical concerns of fiscal policy in demand management

• lags in making and implementing decisions

• lags between decisions and time spending effects economy

• tension between getting timing right and most worth-while spending

• waste

Government budget constraint

Shows that in each period, the use of government funds must equal the source of governments.

Use of funds

Government purchases of goods/services + interest payments on existing government debt + transfer payments from government

Sources of funds (how the gov pays for its spending)

Tax revenue + changes in government debt

Relationship between debt and gov. deficit

• if the gov. spends more than it collects in taxes, it must borrow = debt increases

• if the gov. collects more than it spends, it can pay off debt = debt decreases

Deficit

Primary deficit + interest payments on debt

Primary deficit

Difference between gov. purchases and tax revenue

Intertemporal budget constraint

Looks at government finances over time not just in one period

• says that gov. cannot keep borrowing forever - over time, it must pay back its debt by raising taxes/reducing spending

Two reasons why budget moves back into deficit (G>T)

Automatic stabilisers - more unemployed, less tax collected from individuals/businesses when income falls

Discretionary spending - one-off transfer payments, new infrastructure projects (deliberate actions)