Topic 2

Public Sector and Fiscal Policy

Topic Overview

This topic examines the role of the public sector and fiscal policy in influencing economic activity, particularly in the short run. It addresses questions related to the sources of short-run economic fluctuations and the effectiveness of fiscal policy in stabilizing the economy.

Roadmap

The Main Functions of the Government (the Public Sector):
- The public budget and fiscal policy.
The Keynesian Model of the Goods Market in the Short Run:
- Focuses on how aggregate demand affects economic activity, with an emphasis on household consumption behavior.
Short-Run Effects of Fiscal Policies on Aggregate Outcomes:

1. The Public Sector

Functions of Government

Preserve Market Competition: Prevent monopolies and promote fair competition.
Regulate Monopolies and Mergers: Oversee and control monopolistic practices and corporate mergers.
Correct Suboptimal Market Outcomes: Address issues like externalities and information asymmetry.
Provide Public Goods and Correct Externalities: Supply goods and services that the private sector under-provides (e.g., national defense, clean air) and correct for negative externalities (e.g., pollution).
Redistribution: Transfer wealth to ensure a more equitable society.
Ensure an Equitable Society: Implement policies to reduce income inequality and promote social justice.
Fight Recessions: Use fiscal and monetary policies to stabilize the economy during downturns.
Steer the Economy in the Long Run: Implement policies to promote sustainable economic growth.
Investment in Strategic Sectors, Basic Research, etc.: Allocate resources to areas critical for long-term development.

The Public Budget

A record of all revenues and expenditures of the public sector.
- Revenues:
 - Taxes (excises, levies):
 - Direct: e.g., income tax.
 - Indirect: e.g., VAT, corporate taxes.
- Expenditures:
 - Government consumption on goods and services (G):
 - Purchases of goods (e.g., office equipment, software, cars) and services (e.g., wages of civil servants, armed services, police, teachers, and scientists).
 - Transfers to the private sector (social security benefits or pension payments): TR.
%) $ </li></ul><h5 collapsed="false" seolevelmigrated="true">The Public Budget Balance</h5><ul><li>Public Budget balance = Revenues - Expenditures<ul><li>Balance > 0 (Surplus)</li><li>Balance < 0 (Deficit)</li><li>Primary Budget deficit: public Budget deficit excluding public spending towards interest payments related to public debt.</li></ul></li></ul><h5 collapsed="false" seolevelmigrated="true">Financing the Public Budget Deficit</h5><ul><li>Monetization:<ul><li>Central bank purchases public debt directly from the government.</li><li>Forbidden in most developed countries to ensure the independence of Monetary Policy (many developing ones too).</li></ul></li><li>Selling public debt in bond markets to investors:</li></ul><h5 collapsed="false" seolevelmigrated="true">The Public Debt</h5><ul><li>Government Debt (% of GDP) varies across countries and over time.</li></ul><h5 collapsed="false" seolevelmigrated="true">The Downside of Public Debt</h5><ul><li>Every extra euro of public debt typically generates additional interest payments (adding to the public budget deficit).</li><li>Public budget surpluses are eventually needed to keep the debt in check.</li><li>If public debt is in foreign currency, a depreciation/devaluation of the national currency will increase the burden of debt repayment (debt value in national currency goes up).</li><li>Generates crowding out: public debt lowers private investment and thus the potential growth of the economy.</li></ul><h5 collapsed="false" seolevelmigrated="true">The Risk Premium</h5><ul><li>The difference between the interest rate paid by a “risky” bond relative to one that is perceived as risk-free (e.g., US Treasuries, German bonds).</li><li>Negative economic outlook may increase the risk of default and therefore the premium investors require to hold public debt.</li></ul><h5 collapsed="false" seolevelmigrated="true">Fiscal Policies</h5><ul><li>All the policies that affect the public budget:<ul><li>Taxes (T), transfers (TR), public spending (G).</li></ul></li><li>Expansionary fiscal policy: ↓ taxes, ↑ transfers & public spending.<ul><li>Target: stimulate output and lower unemployment.</li><li>But … higher public budget deficit, crowding out of private investment, higher inflation.</li></ul></li><li>Contractionary fiscal policy: ↑ taxes, ↓ transfers & spending.<ul><li>Target: lower public budget deficit and inflation.</li><li>But … reduces output and increases unemployment.</li></ul></li></ul><h4 collapsed="false" seolevelmigrated="true">2. The Keynesian Model of the Goods Market</h4><ul><li>Based on Keynes’ idea that business cycles are driven by changes in Aggregate Spending.</li><li>Main message:<ul><li>When private consumption and investment are down, the government should increase public spending.</li></ul></li><li>Short run perspective.</li></ul><h5 collapsed="false" seolevelmigrated="true">The Keynesian Model of the Goods Market</h5><ul><li>Graph showing the % US Unemployment (Estimated) over time.</li></ul><h5 collapsed="false" seolevelmigrated="true">The Composition of GDP</h5><ul><li>Consumption (C):<ul><li>Goods (durable + non-durable) and services purchased by consumers.</li></ul></li><li>Investment (I): fixed investment and inventory investment<ul><li>Fixed investment: purchase of capital goods, such as plant, equipment, and housing</li><li>It is the sum of non-residential and residential investment</li><li>Inventory investment is the difference between production and sales.</li></ul></li><li>Government Spending (G)<ul><li>Purchases of goods and services by the government (federal, state, local).</li><li>It does not include government transfers, nor interest payments on the government debt.</li></ul></li><li>Imports (M) = purchases of foreign goods and services by consumers, business firms, and the government.</li><li>Exports (X) = purchases of domestic goods and services by foreigners.</li><li>Net exports (X − M) is the difference between exports and imports, also called the trade balance.<ul><li>Exports > imports ⇔ trade surplus</li><li>Exports < imports ⇔ trade deficit</li><li>Exports = imports ⇔ trade balance</li></ul></li></ul><h5 collapsed="false" seolevelmigrated="true">The Aggregate Demand for Goods</h5><ul><li>The total demand for goods is written as:$ Z \equiv C + I + G + X - M $</li><li>The symbol “$ \equiv $” means that this equation is an identity, or definition.</li><li>To determine Z, some simplifications must be made:<ul><li>Assume that all firms produce the same good, which can then be used by consumers for consumption, by firms for investment, or by the government.</li></ul></li><li>All measures are in real GDP terms (real dollars)</li><li>The economy is producing output (a generic good)</li><li>Assumes:<ul><li>No capital depreciation</li><li>No indirect business taxes</li><li>No subsidies to firms</li><li>No income flows between countries</li></ul></li><li>Thus:<ul><li>GDP=GNP=NI</li></ul></li><li>Assume that firms are willing to supply any amount of the good at a given price, P, to meet the demand in their market.</li><li>Assume that the economy is closed, that it does not trade with the rest of the world - then both exports and imports are zero.</li><li>Under the assumption that the economy is closed, X = M = 0, then:<ul><li>The Demand for Goods$ Z = C + I + G $</li></ul></li><li>Variables that depend on other variables within the model are called endogenous.</li><li>Variables that are not explained within the model are called exogenous.</li><li>Investment here is taken as given, or treated as an exogenous variable:$ I = \bar{I} $</li><li>Government spending, G, together with taxes, T, and transfers TR, describes fiscal policy — the choice of taxes and spending by the government.</li><li>Assume G and TR are also exogenous:<ul><li>Governments do not behave with the same regularity as consumers or firms.</li><li>Macroeconomists must think about the implications of alternative spending and tax decisions of the government.</li></ul></li><li>Disposable income, ($ Y_D $), is the income that remains once consumers have paid taxes and received transfers from the government.<ul><li>$ C = \bar{C} + cY_D $</li></ul></li><li>The function C($ Y_D $) is called the consumption function. It is a behavioral equation, that is, it captures the behavior of consumers.</li><li>Here we assume the consumption increases linearly with$ Y_D $</li><li>This function has two parameters, c and$ \bar{C} $:<ul><li>c = (marginal) propensity to consume, or the effect of an additional dollar of disposable income on consumption.<ul><li>$ 0< c <1 $</li></ul></li><li>$ \bar{C} $= autonomous consumption, the level of consumption that does not depend on income.<ul><li>$ \bar{C} >0 $</li></ul></li></ul></li><li>Assume tax revenues are a share t of aggregate income:$ T = tY $<ul><li>$ 0< t <1 $is the flat (constant) income tax rate</li></ul></li><li>Then disposable income is given by:<ul><li>$ Y_D \equiv Y - T + TR $where$ T = tY $</li><li>Hence:$ Y_D \equiv Y(1 - t) + TR $</li></ul></li><li>$ C \equiv \bar{C} + cY_D $</li><li>$ Y_D \equiv Y(1 - t) + TR $</li><li>Substituting$ Y_D $in C equation:<ul><li>$ C \equiv \bar{C} + c[Y(1 - t) + TR] $</li></ul></li><li>Assuming that exports and imports are both zero, the demand for goods is the sum of consumption, investment, and government spending:<ul><li>$ Z \equiv C + I + G $</li></ul></li><li>Then:<ul><li>$ Z = \bar{C} + c[Y(1 - t) + TR] + \bar{I} + G $</li></ul></li><li>How does aggregate demand change when income increases?</li><li>$ Z = \bar{C} + c[Y(1 - t) + TR] + \bar{I} + G = \bar{C} + cTR + \bar{I} + G + c(1 - t)Y $</li><li>A = autonomous spending, does not depend on Y</li><li>Since$ 0 < c < 1 $and$ 0 < t < 1 \implies 0 < c(1 - t) < 1 $</li><li>Aggregate demand (the Z line) is positively sloped</li><li>Slope less than 1</li><li>How much output do firms supply to the goods market?</li><li>All the production recorded in the GDP, which is…</li><li>…Y!</li><li>This is also (by definition) aggregate income</li><li>How does production change when income changes?</li><li>$ Y = Z $</li><li>Equilibrium in the goods market requires that production, Y, be equal to the demand for goods, Z:</li><li>The equilibrium condition:<ul><li>Production, equals demand Z.</li><li>Demand, Z, in turn depends on income, Y, which itself is equal to production.</li><li>Then:$ Y = \bar{C} + c[Y(1 - t) + TR] + \bar{I} + G $</li></ul></li><li>What is Y to ensure equilibrium (Y=Z)?<ol><li>Solve for Y in the equation above; Call this = equilibrium income, Y*</li><li>See how Y* depends on household behavior, firm behavior, and government policies</li></ol><ul><li>$ Y = \bar{C} + c[Y(1 - t) + TR] + \bar{I} + G $</li></ul></li><li>Three ways to look at this:<ol><li>Graphs to build the intuition</li><li>Algebra to make sure that the logic is correct</li><li>Words to explain the results</li></ol></li><li>Equilibrium in the goods market requires that production, Y, be equal to the demand for goods, Z:</li><li>Collect the Y terms:<ul><li>$ Y[1 - c(1 - t)] = \bar{C} + cTR + \bar{I} + G = A $</li><li>$ Y^* = \frac{1}{1 - c(1 - t)} A $</li></ul></li><li>Autonomous spending:<ul><li>Does not depend on income</li><li>Depends on fiscal policies, household, and firm behavior.</li></ul></li><li>The (spending) multiplier:<ul><li>Since$ 0< c, t <1 $<ul><li>$ \frac{1}{1 - c(1 - t)} > 1 $</li></ul></li></ul></li></ul><h4 collapsed="false" seolevelmigrated="true">3. How does fiscal policy determine output in the short run?</h4><ul><li>The spending multiplier: An increase in autonomous spending<ul><li>An increase in public spending by 1 EUR increases income (and production) by more than 1 EUR</li><li>How does this happen?<ul><li>$ \frac{\Delta Y}{\Delta A} = \frac{1}{1 - c(1 - t)} > 1

The first-round increase in demand, equals $1 billion.

This first-round increase in demand leads to an equal increase in production, or $1 billion,

This first-round increase in production leads to an equal increase in income, also equal to $1 billion.

The second-round increase in demand, equals $1 billion times the propensity to consume c (1-t).

This second-round increase in demand leads to an equal increase in production and thus an equal increase in income.

The third-round increase in demand equals c(1-t) \cdot c(1-t) = c^2(1-t)^2 $</li><li>To summarize:<ul><li>An increase in demand leads to:<ul><li>↑ production (output) => ↑ income => ↑ demand…</li></ul></li><li>The end result is an increase in output that is larger than the initial shift in demand, by a factor equal to the multiplier.</li><li>To estimate the value of the multiplier, and more generally, to estimate behavioral equations and their parameters, economists use econometrics—a set of statistical methods used in economics.</li></ul></li><li>Saving is the sum of private plus public saving.<ul><li>Private saving (S)<ul><li>Saving by consumers.</li></ul></li><li>Public saving (T-G-TR)<ul><li>taxes minus government spending minus transfers.</li></ul></li><li>In the Keynesian model, what happens to Y when saving increases?<ul><li>Define saving:$ S = Y - C - D$$

Changing government spending or taxes is not always easy.

Automatic stabilizers:

Parts of the public budget that respond automatically to a fall in income
E.g., unemployment benefits, income tax revenues

The responses of consumption, investment, imports, etc., are hard to assess with much certainty.

Expectations are likely to matter (people anticipate future increases in taxes as a result of current higher public spending).

Achieving a given level of output can come with unpleasant side effects (e.g., inflation).

Budget deficits and public debt may have adverse implications in the long run.