Fiscal Policy on Government Purchases - Research Paper Example

Fiscal policy refers to the use of government budget (expenditure and revenue collection (taxes)) to influence the aggregate demand and achieve economic objectives such as price stability (Mankiw 2009). By so doing, governments aim to find a balance between reducing the inflation rate and lowering unemployment. The two main components of fiscal policy are taxation, which is the transfer of assets from people to the government and secondly government spending, which is the transfer of assets from government to the public. Stances of Fiscal Policy There are three possible stances of fiscal policy namely neutral, expansionary and contractionary. The stances, simplest, can be defined as follows: A neutral stance of fiscal policy implies a balanced economy which results in a large tax revenue. In this stance, government spending is funded fully by tax revenue and the budget outcome has a neutral effect on the economic activity. An expansionary stance of fiscal policy is a situation where government spending exceeds tax revenue. A contractionary fiscal policy is a situation where government spending is lower than tax revenue. The government has control over both government spending and taxation. By lowering taxes and raising its spending, the government is able to increase the amount of money available to the population and this is referred to as expansionary fiscal policy (Arnold, 2008). A situation where government increases taxes and lowers government spending thereby lowering the amount of money available to the population is referred to as contractionary fiscal policy (Arnold, 2008). Expansionary fiscal policy involves increasing funds allocated to various government agencies/ministries that then make additional consumption expenditures that stimulate aggregate production, thereby increasing the level of employment and boosting income. The overall objective of expansionary fiscal policy is to close a recessionary gap, stimulate economic growth and decrease unemployment rate. In a general perspective, Expansionary fiscal policy tends to increase the output, or national income, whereas contractionary fiscal policy tends to decrease the output, or national income (Arnold, 2008). Keynesian economics suggests that in times of recession and low economic activity, the best way to stimulate aggregate demand is by increasing government spending and decreasing tax rates. When taxes are lowered by the government, consumers have more disposable income. This is represented in the output equation Y = C(Y - T) + I + G + NX, where Y is GDP, C is consumption, I is investment, G is government spending and NX is net exports. A decrease in T, due to a stable Y, leads to an increase in C, and ultimately an increase in Y. By raising government spending on more goods and services, the population who are the providers of these goods and services, receive more money. In terms of the economy as a whole, this is represented by Y = C(Y - T) + I + G + NX. An increase in G leads to an increase in Y (Arnold, 2008). An expansionary fiscal policy makes the population wealthier and increases output, or national income. Fiscal Policy Multipliers While both expansionary and contractionary fiscal policies directly affect the national income, the overall change in output is not always equal to the policy change. There are other factors that either increase or decrease the efficacy of fiscal policy. These factors are known as multipliers. There are two types of multipliers namely tax multipliers and government spending multipliers. When the government increases its expenditure, it increases output or national income directly. There is a greater effect than the actual amount of increase in government expenditures. Since the population is the target of increased government spending, personal incomes and hence consumption, increases. Size of increase depends on MPC (The marginal propensity to consume). MPC is a measure of the amount of an additional dollar of income a consumer is willing to spend on goods and services. The MPC has a value between 0 and 1. A small MPC shows a large amount of savings and a small amount of consumption. A large MPC shows a large amount of consumption and a small amount of savings. The total change in output resulting from a change in government purchases are known as the government spending multiplier is calculated using the formula: (change in government purchases) / (1 - MPC). Working through an example that deals with government spending policy, the total change in output that results from a $20 million increase in government spending if the MPC is 0.8 would be calculated as follows: Government spending multiplier = (change in government purchases) / (1 - MPC). Hence, ($20 million) / (1 - 0.8) = $100 million. A $20 million increase in government expenditure will cause a $100 million increase in output. When government spending increases, the population, who are the recipient of this spending, has more disposable income (Carlberg 2008). With more disposable income, the population spends some and is able save some. The money that they spend goes back into the economy and is saved or spent by somebody else. Government Purchases Government spending is funded in various ways, all of which except taxation are forms of deficit financing. Government purchases are expenditures made in the private sector by all levels government agencies on goods or services. It is the portion of the gross domestic product purchased by the government. The actual purchases are undertaken by individual government agencies. Roads construction, for example, is undertaken with funds allocated to the Ministry of Roads or the Department of Transportation. Economists classify Government spending into three main categories: Government final consumption expenditure: acquisition of goods and services by government for current use to directly satisfy individual or collective needs of members of the community such as: education and healthcare, government's labor force, fixed assets. Gross capital formation: Government acquisition of goods and services meant for future benefit, such as investing on infrastructure or spending research, and is classified as government investment and is usually the largest part of the government spending. Transfer payments: These are payments made by the government to the household sector with no expectation of any productive activity in return, such as Social Security benefits to the elderly and disable, welfare to the poor and compensation to the unemployed. Theoretically, the resulting deficits are paid for by an expanded economy that results during the boom that would follow. If all other factors remain unchanged, any change in government expenditures would shift the aggregate expenditures curve by an equal amount according to Will (2007). A $200-billion increase in government expenditure, for example, will shift the aggregate expenditures curve upward by $200 billion. A $75-billion reduction in government purchases shifts the aggregate expenditures curve downward by an equivalent amount. The first graph - Panel (a) of Figure 2.1, “An Increase in Government Purchases” shows an economy that is in equilibrium at an income of $7,000 billion. If the slope of the aggregate expenditures function (that is, b[1 − t]) is 0.6, the multiplier is 2,5 (two and a half). A $200 billion increase in government expenditure will shift the aggregate expenditures curve upward by the same amount to AE2.  Figure1: An increase in government purchases (assuming a constant price level) Courtesy of web-books.com The economy shown above is initially at equilibrium with a real GDP of $7,000 billion and price level of P1. In the first panel, Panel (a), an increase of $200 billion in government expenditures shifts the aggregate expenditures curve upward by the same amount to AE2, and hence increasing the equilibrium income level in the aggregate expenditures by $500 billion. In the second panel - Panel (b), aggregate demand curve shifts to the right by $500 billion to AD2. The real GDP equilibrium level rises to $7,300 billion, and price level rises to P2. The model of aggregate demand and aggregate supply shown in Panel (b), shows an initial price level of P1, and an initial equilibrium real GDP of $7,000 billion. A $200-billion increase in government expenditure will increase the total quantity of goods and services demanded by $500 billion, at a price level of P1. The aggregate demand curve therefore shifts to the right to AD2 the same amount. The real GDP equilibrium level rises to $7,300 billion only, and the price level rises to P2. Part of the impact resulting from the increase in aggregate demand is absorbed by higher prices, preventing a full increase in real GDP as predicted by the aggregate expenditures model. All other things unchanged, a reduction in government expenditure has the opposite effect. Aggregate expenditures would shift downward by an amount equal to the reduction in aggregate expenditures. According to the aggregate demand and aggregate supply model, the aggregate demand curve shifts to the left by an amount equal to the product of the initial change in autonomous aggregate expenditures and the multiplier (Arnold, 2008). Both the Real GDP and the price level would fall. The fall in the real GDP is less than it would occur if the price level stayed constant. Works Cited Arnold Roger. Economics (8th ed). South-western/Cengage Learning. 2008. Carlberg Michael. 2008. Inflation and Unemployment in a Monetary Union. Viewed 15th August, 2010 http://www.sparknotes.com/economics/macro/taxandfiscalpolicy/section1.html Mankiw Gregory. Brief Principles of Macroeconomics. South-Western College Publishers. 2009. Will Cheryl. Fiscal policy and economic growth: Lessons for Eastern Europe and Central Asia. World Bank Publication. 2007. Read More