Lecture 3_KeynesianCross

Taxes and Expenditures by Governments

• Taxes: Governments in advanced economies collect 35-50% of National Income in taxes.

• Expenditures: Taxes fund:

  • Public Goods: Infrastructure, public order and safety, defense.

  • Welfare State: Education, retirement benefits, health care, income support.

  • Fiscal Stimulus: Used to stabilize business cycles.

Key Facts on Taxes and Expenditures

1. Government Growth: Size of government relative to national income grows from less than 10% in less developed economies to 30-50% in advanced economies.

2. Government Size Stability: Remains stable in the richest countries after 1980.

3. Welfare State Expansion: Growth is primarily due to the expansion of:

   • Public education.

   • Public retirement benefits.

   • Public health insurance.

   • Income support programs.

4. Deficits in Rich Countries: Most wealthy nations run deficits and have significant public debt relative to GDP, especially highlighted during the Great Recession (2008-2010).

Two Forms of Expenditures

• Entitlement (Mandatory) Spending: Funds for programs with automatically set funding levels based on eligible recipients (e.g., Medicare, Social Security).

• Discretionary Spending: Optional spending determined by yearly appropriations at Congress's discretion (e.g., defense).

• Expansion Against Recessions: To counter economic downturns, discretionary expenditures can be expanded.

Fiscal Stimulus: Scenarios

• Equilibrium Output: Given by the equation: (Y = \frac{1}{1-c_1}(c_0 + I + G - c_1T))

• Scenarios:

  1. Increase in government spending (G): ( \Delta Y / \Delta G )

  2. Increase in taxes (T): ( \Delta Y / \Delta T )

  3. Equal increase in government spending and taxes: ( \Delta Y / \Delta G) (comparing financing methods is crucial).

Spending Multipliers in the Real World

• Multiplier Estimates: Research indicates that the fiscal multiplier from temporary, deficit-financed increases in government purchases is likely between 0.8 to 1.5, though it could range from 0.5 to 2.

• Citation: Ramey, Valerie A. (2019) discusses the evidence from U.S. data post-financial crisis.

• Multiplier Model: Observed that if (c_1 = 0.5), then ( \frac{1}{1-c_1} = 2).

What is Missing in Current Models?

• Incorporating more variables into fiscal models affects the fiscal multiplier.

• Future chapters will include discussions on:

  • Money and interest rates.

  • Monetary policy.

  • Labor market dynamics, unemployment, and inflation.

Outline of Topics

• GDP Composition: (Y = C + I + G + NX)

• Consumption Function and Keynesian Cross.

• Investment-Saving Interpretation.

• Government, Fiscal Policy, and Multipliers.

• Automatic Stabilizers and remarks on fiscal policy.

Automatic Stabilizers

• In addition to discretionary fiscal policies, automatic stabilizers are built-in mechanisms of the tax-and-transfer system that help stabilize economic fluctuations (business cycles).

• These policies operate based on rules and do not require specific legislative actions.

Example 1: Unemployment Insurance (UI)

• During recessions, national income (Y) decreases, leading to higher unemployment.

• UI programs provide temporary financial assistance based on previous earnings, supporting consumers and reducing recession impacts on consumption.

Example 2: Progressive Income Tax System

• Most countries implement a progressive income tax, where higher earnings lead to higher tax rates.

• In economic expansions, as Y increases, tax contributions increase, rendering the economy more stable as consumption becomes less sensitive to income changes.

Some Remarks on Fiscal Policy

• Implementing changes in government spending or taxes is often slow; legislative processes could take considerable time (e.g., 99 days for Korea's recent stimulus plan).

• When interest rates are near zero, fiscal policy becomes vital due to limited options for central banks.

Next Class Overview

• Upcoming lessons will focus on financial markets and the determination of interest rates under various monetary policy impacts.

• Reference to Blanchard, Chapter 4, set for further exploration.