Week 14 Fiscal Policy and

Monetary Policy CHAPTERS 24 & 25

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 Fiscal policy - The government’s spending and taxing policies.
*Monetary policy - The behavior of the Federal Reserve concerning the
nation’s money supply. See, Week12_Monetary system_ch25

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 Fiscal Policy - Government in the Economy
Discretionary fiscal policy - Changes in taxes or spending that are the
result of deliberate changes in government policy.

Government Purchases (G), Net Taxes (T), and Disposable Income (Yd)

Net taxes (T) - Taxes paid by firms and households to the government
minus transfer payments made to households by the government.
Disposable, or after-tax, income (Yd) - Total income minus net taxes: Y − T.

Disposable income ≡ Total income − Net taxes

Yd ≡ Y − T

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  FIGURE 24.1 Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow
of Income

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 The disposable income (Yd) of households must end up as either consumption
(C) or saving (S). Thus,
Yd  C  S
Because disposable income is aggregate income (Y) minus net taxes (T), we
can write another identity:
Y  T  C S
By adding T to both sides:
Y  C S  T
Planned aggregate expenditure (AE) is the sum of consumption spending by
households (C), planned investment by business firms (I), and government
purchases of goods and services (G).

AE  C  I  G

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 Budget deficit - The difference between what a government spends and what
it collects in taxes in a given period: G − T
Budget deficit ≡ G − T or G > T

Adding Taxes to the Consumption Function

To modify our aggregate consumption function to incorporate disposable

income instead of before-tax income, instead of C = a + bY, we write

C = a + bYd
or
C = a + b(Y − T)

Our consumption function now has consumption depending on

disposable income instead of before-tax income.

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 Planned Investment
The government can affect investment behavior through its
tax treatment of depreciation and other tax policies.

Planned investment depends on the interest rate, both of

which we continue to assume are fixed for purposes of this
chapter.

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  FIGURE 24.2 Finding Equilibrium
Output/Income Graphically

Because G and I are

both fixed at 100, the
aggregate expenditure
(AE) function is the
new consumption
function displaced
upward by
I + G = 200.

Equilibrium occurs at
Y = C + I + G = 900.

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 The Saving / Investment Approach to Equilibrium
saving/investment approach to equilibrium:

S+T=I+G
To derive this, we know that in equilibrium, aggregate output (income) (Y)
equals planned aggregate expenditure (AE).

By definition, AE equals C + I + G, and by definition, Y equals C + S + T.

Therefore, at equilibrium:

C+S+T=C+I+G
Subtracting C from both sides leaves:

S+T=I+G

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 Fiscal Policy at Work: Multiplier Effects
At this point, we are assuming that the government controls G and T. In this
section, we will review three multipliers:

Government spending multiplier

Tax multiplier
Balanced-budget multiplier
The Government Spending Multiplier
1 1
Government spending multiplier  
MPS 1  MPC
- The ratio of the change in the equilibrium level of output to a change
in government spending.
*Marginal Propensity to Save (MPS) is the portion of each extra dollar of a
household’s income used for saving.

*Marginal propensity to Consume (MPC) is the proportion of an aggregate

raise in pay that a household spends on the consumption of goods and
services, as opposed to saving it.

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  FIGURE 24.3 The Government
Spending Multiplier

Increasing government
spending by 50 shifts
the AE function up by
50.

As Y rises in response,
additional consumption
is generated.

Overall, the equilibrium

level of Y increases by
200, from 900 to 1,100.

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 The Tax Multiplier
Tax multiplier - The ratio of change in the equilibrium level of output to a
change in taxes.

 1 
 Y  (initial increase in aggregate expenditure)   
 MPS 
Because the initial change in aggregate expenditure caused by a tax change of
∆T is (−∆T × MPC), we can solve for the tax multiplier by substitution:


Y  (  T  MPC )  
1   MPC 
  T   
 MPS   MPS 
Because a tax cut will cause an increase in consumption expenditures and
output and a tax increase will cause a reduction in consumption expenditures
and output, the tax multiplier is a negative multiplier:

tax multiplier    
MPC

MPS

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 The Balanced-Budget Multiplier
- The ratio of change in the equilibrium level of output to a change in
government spending where the change in government spending is
balanced by a change in taxes so as not to create any deficit. The
balanced-budget multiplier is equal to 1: The change in Y resulting from
the change in G and the equal change in T are exactly the same size
as the initial change in G or T.

balanced-budget multiplier  1

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 TABLE 24.4 Summary of Fiscal Policy Multipliers
Final Impact on
Policy Stimulus Multiplier Equilibrium Y
Government Increase or decrease in the 1 1
spending level of government G 
multiplier purchases: ∆G
MPS MPS

Tax multiplier Increase or decrease in the  MPC  MPC

level of net taxes: ∆T T 
MPS MPS

Balanced- Simultaneous balanced-budget

budget increase or decrease in the 1 G
multiplier level of government
purchases and
net taxes: ∆G = ∆T

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 The Economy’s Influence on the Government Budget
Automatic stabilizers - Revenue and expenditure items in the federal
budget that automatically change with the state of the economy in such
a way as to stabilize GDP.
Automatic destabilizer - Revenue and expenditure items in the
federal budget that automatically change with the state of the economy
in such a way as to destabilize GDP.
Fiscal drag - The negative effect on the economy that occurs when
average tax rates increase because taxpayers have moved into
higher income brackets during an expansion.

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 Full-Employment Budget
Full-employment budget - What the federal budget would be if the economy
were producing at the full-employment level of output.
Structural deficit - The deficit that remains at full employment.

Cyclical deficit - The deficit that occurs because of a downturn in the

business cycle.

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 Monetary policy can be described either in
terms of the money supply or in terms of the interest
rate.
Refer to Week12_Monetary system_ch25

•Changes in monetary policy can be viewed either in

terms of a changing target for the interest rate or in terms
of a change in the money supply.

•A target for the Central Bank interest rate(s) affects the

money market equilibrium, which influences aggregate
demand.

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 With effect from 2 Sept
1998, BNM introduced
a fixed exchange rate
regime.

21 July 2005 –
Malaysia removed its
peg to the US dollar
with a managed float
weighted against a
basket of currencies.

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 Bank Negara Malaysia announced (updated 28 January 2003) the
implementation of a number of policy (additional monetary)
measures.

•To improve the efficiency of the intermediation process in

providing financing to productive economic activities; and

•To enhance the efficiency of the operations of the money

market to allow interest rates to reflect underlying liquidity
conditions.

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 These objectives will be achieved through the following policy
measures:
1. Maintain tight monetary policy. Despite a slowdown in growth, it is
essential to maintain a tight monetary policy to contain inflationary
pressures arising from the depreciation of ringgit. This policy is intended to
strengthen the foundation on which the prospect for sustainable growth in
the medium and longer term would be enhanced.

2. The interest rate structure will be streamlined to reflect liquidity

conditions in the market. A more orderly term structure of interest rates
that would better reflect the liquidity in the financial system. For this
purpose, the 3-month Bank Negara intervention rate, currently at 10%,
would under present conditions, be adjusted upwards to 11%.

3. Reduce the statutory reserve requirements (SRR) of

commercial banks, merchant banks and finance companies from the
current level of 13.5% to 10% of their eligible liabilities, effective 16
February 1998. Banking institutions should channel their resources to
productive activities to support the economic recovery of the country.

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 Monetary Policy - Reserve Bank of Australia

•involves setting the interest rate on overnight loans in the money

market (‘the cash rate’). The cash rate influences other interest
rates in the economy, affecting the behaviour of borrowers and
lenders, economic activity and ultimately the rate of inflation.

•a duty to maintain price stability, full employment, and the

economic prosperity and welfare of the Australian people.

•to achieve these statutory objectives, the Bank has an ‘inflation

target’ and seeks to keep consumer price inflation in the economy to
2–3 per cent, on average, over the medium term. Controlling
inflation preserves the value of money and encourages strong and
sustainable growth in the economy over the longer term.
http://www.rba.gov.au/monetary-policy/

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