Macro Economics: Impact of Government on Equillibrium Income

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Effect of Changes in Taxes, Subsidy and Government Expenditure on Equilibrium Income is discussed.

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Macro Economics: Impact of Government on Equillibrium Income

  1. 1. IMPACT OF GOVERNMENT EXPENDITURE AND TAXES ON INCOME DR. LAXMI NARAYAN ASSISTANT PROFESSOR OF ECONOMICS GOVT. P.G. COLLEGE MAHENDERGARH
  2. 2. Lecture Outline  Fiscal policy: Rational and Instruments  Government expenditure and tax function.  Determination of National Income in a Three Sector Economy.  Impact of Changes in Government Expenditure and Tax Rate on Equilibrium GDP
  3. 3. Govt. Expenditure and Taxes: Instruments of Fiscal Policy Govt. Expenditure Policy: .Expenditure for buying goods and services and for transfer payments. Other instruments are fiscal policy are Public Debt Policy and Deficit Financing Taxation Policy: Govt. uses taxes for affecting real purchase power for desired policy outcomes.
  4. 4. Why Fiscal Policy?  Growth with Full Employment  Price Stability  Reduction in Economic inequalities  Fiscal policy can be expansionary or contractionary.  Expansionary fiscal policy increases the output, or national income, while contractionary fiscal policy decreases the output, or national income.
  5. 5. Government Expenditure Function  The government expenditure function shows the relationship between govt. expenditure and GDP. 0 200 Government.Exp.(G) Govt. expenditure is constant at any level of GDP Real GDP (Rs. Crore) G. Exp (Rs. Crore) 0 100 200 100 300 100 500 100 300 500 Real GDP(Y) G = 100 G is autonomously fixed according to Government Budget Policy for each year.
  6. 6. Government Tax Function 0 40 TaxRevenue(T) Real GDP (Rs. Crore) Tax Rate (%) G. Exp (Rs. Crore) 0 20 00 200 20 40 500 20 100 900 20 180 500 900 Real GDP(Y) 200 100 180 T=f(Y)
  7. 7. Budget Surplus(Public Saving) Function(T-G) 0 -60 BudgetSurplus(T-G) Y G T T-G 0 100 00 -100 200 100 40 -60 500 100 100 0 900 100 180 80 1500 100 300 200500 900 Real GDP(Y) 200 80 200 T-G = f(Y) -100 1500
  8. 8. Domestic Saving Function (S + T-G) 0 Saving(T-G) Real GDP(Y) Sd = S+(T-G) = f(Y)
  9. 9. Equilibrium GDP Determination Equilibrium will occur when there is no tendency for an economy to change. There are two alternate approaches: Total Approach: Equilibrium may occur when planned aggregate expenditure(AE) is equivalent to aggregate output(Y) that is AE = Y Leakage Injection Approach: Equilibrium also can be determined when: INJECTION = LEAKAGE
  10. 10. Total Approach (AE=Y) Aggregate Expenditure (AE) AE is the sum of desired consumption, desired investment and government expenditure. Symbolically: AE = C+I+G C = a + b Yd, where a is autonomous consumption (fixed irrespective of the income earned) and bYd is an amount that depends on the disposable income and b=MPC. I = Public Investment Expenditure (independent of GDP) G = Government Expenditure (independent of level of GDP)
  11. 11. Total Approach (AE=Y) Aggregate Output (Y) Aggregate output is the sum of consumption, savings and Taxes. Symbolically: Y = C+S+T Aggregate output(Y) is a 45o line from the origin. Each point on the 45o line shows the equality between desired aggregate output and desired AE.
  12. 12. Aggregate Expenditure and Aggregate Output Real GDP Y Desired Consumption Expenditure C = 75+0.75Y Desired Investment Expenditure I = 200 Desired Government Expenditure G = 100 Aggregate Expenditure AE=C+I+G 0 75 200 100 375 200 225 200 100 575 400 375 200 100 675 500 450 200 100 750 800 675 200 100 975 1500 1200 200 100 1500 2000 1575 200 100 1875 2500 1950 200 100 2250 3000 2325 200 100 2625 AE>Y AE<Y AE=Y
  13. 13. Aggregate Expenditure 0 Real GDP (Y) Aggregate.Expenditure Aggregate Expenditure = C+I+G
  14. 14. Impact of Change in Government Expenditure on Aggregate Expenditure 0 Real GDP (Y) Aggregate.Expenditure C+I+G
  15. 15. Y = C+S+T 45 Aggregate Output(Y) Real GDP (Y) Aggregate.Expenditure C+I+G Y A 45 line is drawn from the origin showing equality between desired output and desired AE. Each point on the 45 shows the equality between AE and GDP. Y = C+S+T Y-T = C+S Yd = C+S Yd is the spendable income of the people.
  16. 16. Y = AE 45 Determination of Aggregate Income Real GDP (Y) Aggregate.Expenditure(AE) A 45 line is drawn from the origin showing equality between desired output and desired AE. Each point on the 45 shows the equality between AE and GDP. E YE
  17. 17. Total Approach(Income – Exp. Approach) Y=AE Y AE 0 AE=C+I+G Ye Y1Y2 Production At Y2, Y < AE Unplanned decrease in inventories } { Determination of Aggregate Income E
  18. 18. Withdrawal Equilibrium income (or equilibrium GNP) is reached when Y = AE Injection= Injection- Withdrawal (Saving-Investment) Approach C + S + T = C + I + G S + T = I + G Now S + T = I + G I = S+T- G I = Sd =Injection Withdrawal
  19. 19. Diagrammatic Representation Injection- Withdrawal (Saving-Investment) Approach At Y1, J < W  unintended inventory investment At Y2, J > W  unintended inventory disinvestment Y AE 0 I0 Sd = S+(T- G) I0 Ye Y1Y2 { } Production E Production
  20. 20. We know AE = C + I + G and C=a+bY Estimating Equation Putting the value of C AE = a+bY+I+G At Equilibrium AE=Y, thus Y = a+bY+I+G  Y - bY= a+I+G  Y (1-b)= a+I+G Investment Multiplier b = MPC Equilibrium GDP
  21. 21. We know AE = C + I + G and C=a+b(Y-T) Equilibrium GDP with Lump sum Tax Putting the value of C AE = a+b(Y-T)+I+G At Equilibrium AE=Y, thus Y = a+bY-bT+I+G  Y-bY= a-bT+I+G  Y (1-b)= a-bT+I+G Investment Multiplier b = MPC Equilibrium GDP with Lump Sum Tax Y = 1 1-b (a-bT+I+G)
  22. 22. We know AE = C + I + G and C=a+b(Y-tY) Equilibrium GDP with Proportionate Tax Putting the value of C AE = a+b(Y-tY)+I+G At Equilibrium AE=Y, thus Y = a+bY-btY+I+G Y-bY+btY = a+I+G  Y(1-b+bt)= a-bT+I+G  Y [1-b(1-t)]= a+I+G Investment Multiplier b = MPC Equilibrium GDP with Lump Sum Tax Y = 1 [1-b(1-t)] (a+I+G)
  23. 23. Real GDP (Y) E I I0 Sd Sd Ye S&I Panel-(B) Y1 Real GDP (Y) E 0 Ye Agg.Exp. Y=AE 45 Panel-(A) Y1 Y2 Y2 0 Diagrammatic Representations of Two Approaches At OYe - Equilibrium Y=AE in panel (A) and Sd =II0 in Panel (B) At OY1 - Disequilibrium AE>Y in panel (A) and II0 > Sd in Panel (B) At OY2 - Disequilibrium AE<Y in panel (A) and II0 < Sd in Panel (B)
  24. 24. Impact of Change in G on Equilibrium GDP We know Y = a+b(Y-tY) + I + G……………(i) Now suppose govt. increase its expenditure by G and as a result of this income increases to Y1we have : Y1= a + b(Y1-tY1) + I + G + G ………(ii) Subtracting eq (ii) from Eq (i), we have: Or Y1 -Y = b[(Y1-Y) –t (Y1-Y)] +G Y1 -Y= [a –a] + [b(Y1-tY1)- b(Y-tY)]+ [I-I] + [G-G] + G Let Y1 –Y = Y Then Y = b[Y - tY]+ G
  25. 25. Impact of Change in G on Equilibrium GDP From the previous slide, we have Y = b[Y - tY]+ G or Y - bY +b tY =G or Y[1 - b + bt] =G or Y = 1 . G [1 - b + bt] Y 1 [1 - b + bt]=G Y 1 [1 - b (1-t)]=G or or Kg = = Govt. Multiplier
  26. 26. Real GDP (Y) E 0 Ye AggregateExp. Y=AE 45 Y1 Impact of Change in G on Equilibrium GDP E1 Govt. MultiplierChange in GDP = x Y 1 1 - b (1-t)= G Change in G
  27. 27. Impact of Change in G on Equilibrium GDP Govt. MultiplierChange in GDP = x Y 1 1 - b (1-t)= . G Change in G We know that: Sd= S+T-G Increase in G would reduce the domestic savings and would shift Sd curve to the right increasing income from OYe to OY1. Y1 E1 Sd-G
  28. 28. Impact of Change in T(Tax Collection) on Equilibrium GDP We know Y = a+b(Y-T) + I + G……………(i) Now suppose Tax collection increases by T and as a result of this income decreases to Y1we have : Y1= a + b(Y1-T-T) + I + G ….………(ii) Subtracting eq (ii) from Eq (i), we have: Or Y1 -Y = b[(Y1-Y)] –b (T)] Y1 -Y= [a –a] + [b(Y1-T-T)- b(Y-T)]+ [I-I] + [G-G] Let Y1 –Y = Y Then Y = bY - bT
  29. 29. Impact of Change in T(Tax Collection) on Equilibrium GDP From the previous slide, we have Y = bY - bT Y - bY = -bT Y (1- b) = -bT or Y = [1 – b ] 1 -bT or Y -b (1 – b) =T
  30. 30. Real GDP (Y) E 0 Ye AggregateExp. Y=AE 45 Y1 E1 Impact of Change in T(Tax Collection) on Equilibrium GDP Exp. MultiplierChange in GDP = x Y -b 1 – b= T Change in T
  31. 31. We know that: Sd= S+T-G Increase in T would increase the domestic savings and would shift Sd curve to the left decreasing income from OYe to OY1.GDP (Y) I I0 Sd Sd Ye Saving&Investment 0 Y1 E1 E MultiplierChange in GDP = x Y -b 1 – b= T Change in T Impact of Change in T(Tax Collection) on Equilibrium GDP
  32. 32. Jain, T.R and Majhi, B.D., “Macroeconomics” V.K. Publications. Rana, K.C. and Verma, K.N., “Macro Economic Analysis” Vishaal Publications. Rana, A.S., “Advance Macro Economics-Theory and Policy,” Kalyani Publishers. Shapiro, E, “Macro Economic Analysis” Galgotia Publications. REFERENCES
  33. 33. Discuss the effect of change in the government expenditure on equilibrium real GDP.  Discuss the impact of changes in tax rate on the equilibrium GDP.  Why there is a parallel shift in Aggregate Expenditure function when government expenditure changes and non parallel shift when tax rate changes.  Explain the determination of National income in a three sector economy. FAQs

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