Instead of Y = C+I we will have Y = C+I+G

and the diagram will look like this:

Prescription: Fiscal Policy

The point is

1) to understand how unemployment can arise in a market economy, and
2) to suggest how the problem might be solved or made less serious.

The prescription is addressed to the national government.

Fiscal Policy

When a national government makes decisions on taxation and spending with a view to influencing the level of production and employment, this is called "fiscal policy."

Suppose:

= 3.333.

Equilibrium income is

"Full employment" production is 6000.

We'll have to do a bit of algebra to figure it out. Let X be (as usual!) the unknown increase in government spending. Using the multiplier approach the increase in equilibrium income will be

X* = X*3.333.

X*3.333=1000

Solving for X, the unknown, we get

X=1000/3.333 = 300

In the figure, C+I+G shows the situation before the government intervention. Government spending is at 250 and equilibrium production is at 5000.

Figure 2: Fiscal Policy

To allow for taxes, we will have to distinguish between income before and after taxes. The term we use for income after taxes is "disposable income:"

Disposable Income

Disposable income is income net of taxes, and is the income the individual is able to divide between consumption and spending.

C = a + b(Y_d) = a + b(Y-T)

where T is taxes and Y_d is disposable income.

Starting from

Y=C+I+G

and

C=a+b(Y-T)

This difference:

• Taxes reduce equilibrium income and expenditure.
• Each dollar of additional taxes cuts equilibrium income by dollars.

We will again use these assumptions:
C = 500 + 0.7*(Y-T)
I=1000
G=500
This gives
Y = 3.333*(500+1000+500)
= 3.333*2000 = 6667
Now add T=500
We have
C = 500 + 0.7*(Y-T) = 500 + 0.7*Y - 0.7*T
C = 500 + 0.7*Y - 0.7*500
= 500 + 0.7*Y - 350 = 150 + 0.7*Y
Y = 3.333*(150+1000+500)
= 3.333*1650 = 5500
So the introduction of a tax of 500 (billion dollars) has reduced equilibrium income by 1167 (billion dollars), from 6667 to 5500.

An alternative way to get the equilibrium with taxes is to use the multiplier formula

In this example, that is (again)

Y = 3.333*2000 - 2.333*500 = 5500.

Suppose the government keeps a balanced budget, increasing both spending and taxes by B (for Balanced Budget). B goes from zero to 500. With B = G = T = 0, we have autonomous spending of 1500 and a multiplier of 3.333, equilibrium income is

3.333*(1500)=5000,

as we have seen in earlier examples.

Now both government purchases, G, and taxes, T, increase to 500.

equilibrium income is computed as

Y = 3.333*2000 - 2.333*500 = 5500.

We see that after government spending and taxes are introduced -- even though the budget is balanced -- equilibrium income is increased, and it is increased by exactly the amount of the balanced budget.

Recessionary Gaps

A recessionary gap exists when production is less than full employment production. It might also be called a "contractionary" gap, since production is "contracted" below full employment. The appropriate policy is one that would "expand" aggregate demand, an "expansionary" policy. "Expansionary" fiscal policies include increases in government spending and cuts in taxes, or some combination of these, such as increase in the size of a balanced government budget.

Inflationary gaps.

An inflationary gap also, called an expansionary gap, exists when equilibrium income is greater than full employment income. In such a case, businessmen would compete against one another to get resources with which to produce the output that is demanded, and costs would rise, with prices following them up. An appropriate policy for an expansionary gap would be a policy that reduces, or "contracts," aggregate demand -- a contractionary policy.

Assume:

Y= 2500*3.33 - 500*2.33 = 7167.

But "full employment" production is 6000. They want to adopt contractionary policies to reduce equilibrium production to 6000, in the hope that this will prevent further inflation.

An Inflationary Gap

Here are two policies that could meet that target:

Cut government spending by 350.

Since the autonomous spending multiplier is 3.33 in this model, this policy would reduce equilibrium income by 350*3.33 = 1167. Thus, equilibrium production would be reduced from 7167 to 6000. The government would then run a budgetary surplus of 350.

Increase taxes by 500.

Since the tax multiplier is 2.33, this would reduce the equilibrium production by 500*2.33 = 1167 -- again, just enough to get equilibrium income down to the target of 6000. The government would then run a budgetary surplus of 500.

Here is a diagram, set up in the usual way, to illustrate a reduction in government spending as a remedy for an expansionary gap.

However, debt service is a burden.

• Taxes must be collected to pay the interest on the debt, and there is no such thing as a good tax.
• On the average, those to whom the interest is paid are richer than the taxpayers who pay it.
• If the debt and the debt service increase more rapidly than production itself, the increase is not sustainable.
• Many economists would worry that government borrowing would crowd out private borrowing for investment, so that people would be worse off in the future.

Since there are good reasons to be concerned about government deficits and debt, we might wonder why large deficits and expanding government debt have been so common, even with "conservative" governments. Perhaps the Simple Keynesian model has the answer to that question: perhaps the deficits really do stimulate production, and that is a temptation even conservative governments find it difficult to resist!

Automatic Stabilizers

There is another, more automatic way that spending and taxation can influence the economy.

Some kinds of taxes rise more than proportionately when income increases.

A progressive income tax

Some kinds of transfer payments and government purchases rise when income drops.

Unemployment compensation and income supplements for poor people

An example is the year 1997 in the U. S. A. By the end of the year, the deficit was much lower than anyone had anticipated. This happened because, over the year, steady growth of production reduced unemployment to its lowest rate in twenty-five years. This increased growth raised tax revenues and cut transfers, reducing the government deficit. Incidentally, the multiplier theory tells us that the dropping deficit will also have slowed the growth of production, partly offsetting the rise in aggregate demand that would otherwise have occurred.

We may also hope that the government deficits in recession periods will be offset by government surpluses in boom periods. This is called a "cyclically balanced budget," and probably is the only realistic kind of balanced budget. Unfortunately, it is a potentiality -- a hope -- not a fact.