Lecture slides for an undergraduate course on Basic Macroeconomics that I taught in the Fall of 2007. This lecture focuses on fiscal policy.

1. GOVernment in the economy
Part I: The Effects of Fiscal Policy

2. Review
• At a minimum, government significantly influences
economic activity by providing the framework within which
households and firms operate.
• More directly, government is itself an economic agent by
virtue of its two broad policy instruments:
• Monetary Policy: the government exercises control over
an economy’s money supply.
• Fiscal Policy: the government levies taxes and also
spends on goods and services.
How government affects the economy.

3. Taxation
• Taxes represent funds that have to be paid to the
government out of our income.
• This means that our incomes have to be divided not just
between savings and consumption, but taxes as well:
Y = C + S + T
• The taxes that government collects (T) are what finance
government expenditure (G).
• If G < T, the government is running a surplus.
• If G > T, the government is running a deficit.
• If G = T, we have a balanced budget.
Some insights into how taxes factor into economic analysis.

4. Taxes and Consumption
• The difference between our income and the amount of
taxes that we have to pay is our disposable income.
Yd = Y – T
• This means that consumption is really a function of our
disposable income:
C = a + bYd
• Substituting the former into the latter yields:
C = a + b(Y – T)
• This implies that the saving function is now:
S = –a + (1 – b)(Y – T)
Incorporating taxation into the consumption function.

5. Government Spending
• Consider: whether government spends or not does not
necessarily have anything to do with how the economy is
doing.
• Government projects can be undertaken for political
rather than economic reasons.
• Government can (hypothetically) spend whether or not it
has the necessary funds to finance its projects.
• If this is the case, we can consider government spending
as another autonomous variable.
Putting the “G” in Planned Aggregate Expenditure (i.e. C + I + G).

6. Output and Fiscal Policy
• A more complete model of planned aggregate expenditure:
AE = C + I + G
• Substituting:
AE = a + b (Y – T) + I + G
• The equilibrium condition:
Y = AE
• Thus (and rearranging):
Y = (a + I + G) + bY – bT
Putting it all together.

7. Output and Fiscal Policy
Putting it all together.
We have now derived the equilbrium condition:
Y = 1 ( a + I + G – bT)
1 – b
Consider:
Any change in government
spending changes equilibrium
output by:
Any change in taxation
changes equilibrium output by:
1 – b
1
1 – b
b
–

8. Output and Fiscal Policy
Putting it all together.
We have now derived the equilbrium condition:
Y = 1 ( a + I + G – bT)
1 – b
Consider:
Any change in government
spending changes equilibrium
output by:
Any change in taxation
changes equilibrium output by:
MPS
1
MPS
MPC
–

9. Output and Fiscal Policy
Putting it all together.
We have now derived the equilbrium condition:
Y = 1 ( a + I + G – bT)
1 – b
The Government
Spending Multiplier:
The Tax Multiplier:
MPS
1
MPS
MPC
–

10. Fiscal Stimuli
• Recessions represent a downturn in economic performance.
• Recall: they are defined as a decline in output over two
consecutive quarters.
• If ouput declines, it must mean that investments have
declined.
• Government spending can be an effective tool to offset
recessions.
Case 1: Recession
1
MPS
– ∆ I
1
MPS
∆ G
Decrease in Planned
Investments
Increase in Government
Spending
+ = 0

11. Fiscal Stimuli
• An economy may be said to be “overheating” when
economic performance leads to rapidly rising output and
income over a short interval.
• The immediate consequence of this is rising inflation and a
rising cost of living.
• Overheating is often kept in check by a commensurate
increase in taxes.
• Fiscal Drag: with rising incomes come rising tax revenue.
Case 2: “Overheating”

12. Fiscal Stimuli
Case 3: Balanced Budget Spending
∆ G = ∆ T
What would happen if the govenrment finances an
increase in expenditure by an equal increase in taxes?
From the multiplier:
The change in equilibrium output from a
change in taxes is given by:
MPS
MPC
– ∆ T
The change in equilibrium output from a
change in government spending is given by: MPS
1
∆ G

13. Fiscal Stimuli
Case 3: Balanced Budget Spending
The total change in output from “balanced budget spending”:
∆ Y =
MPS
MPC
– ∆ T
MPS
1
∆ G
Since ∆ G = ∆ T:
∆ Y =
MPS
MPC
– ∆ G
MPS
1
∆ G

14. Fiscal Stimuli
Case 3: Balanced Budget Spending
Simplifying:
∆ Y =
MPS
1 - MPC
∆ G
However, (1 – MPC) = MPS! Therefore:
∆ Y =
MPS
MPS
∆ G
∆ Y = ∆G