Principles of Macroeconomics

By Dr. Rashmi Kumar| SBSEC

Study Material
Of

Principles Of Macroeconomics
For

B.com (Prog) 6th Sem ‘2022

Paper Code – 62275604

By

Dr. Rashmi Kumar

Dept of Economics
Shaheed Bhagat Singh (Eve) College

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 Principles of Macroeconomics
By Dr. Rashmi Kumar| SBSEC

NATIONAL INCOME DETERMINATION IN AN OPEN ECONOMY WITH

GOVERNMENT

o Let’s introduce the role and effect of government in the determination of national income.
Government expenditure directly increases the aggregate expenditure in the economy, which in
turn increases the level of income generation. In this way government expenditure serves as an
injection to boost the economist activities. The government imposes taxes on men and material,
which serves as a leakage from the flow of national income. Similarly, government gives subsidies
to individuals and firms, it serves as an injection in the economic activities.
o Government Spending
A distinction is necessary between :
(i) Government consumption expenditure on Goods and services or desired government
purchases (denoted as G).
(ii) Government transfer payments.
1. Government Purchases (G)
Presently, all the governments of the world economies are 'Welfare Governments. They spend
money on welfare programmes of the people and of business organisations. When the government
spends money on the purchase of goods and services, it directly affects the aggregate spending of
the economy as a whole and also the national income determination. Government purchases is a
part of aggregate expenditure.
2. Transfer Payments
Government makes transfer payments like state pension, unemployment benefits, etc. to
individuals, who will spend some part of the money on buying goods and services. Transfer
payments affect aggregate expenditure indirectly. Transfer payment raise disposable income
which, in turn, raises the desired consumption expenditure.
o Tax Revenues
Taxes have opposite effect on individuals as compared to transfer payments. Taxes reduces the
disposable income which, in turn, reduces the desired consumption expenditure.
Net taxes (T) are total tax revenues received by the government minus total transfer payments
made by the government. Net taxes are generally positive.
o The Budget Balance
Budget is the annual financial statement of accounts for the preceding and current year, and the
estimates of revenue and expenditure of the Coming year. In short, it is financial statement of tax
revenues and expenditure of the government.
Budget can be of two types. They are:
1. Balanced Budget
It occurs when government's total revenue equals total expenditure, it is known as balanced
budget.
2. Unbalanced Budget
It occurs when total revenue is not equal to total expenditure. Unbalanced budget is again
divided into two types:
(a) Surplus Budget: When total expenditure of the government is less then total revenue
collected.
(b) Deficit Budget: If total expenditure of the government is more than total revenue collected
by the government by the ways of taxes, etc. it is known as deficit budget.
Budget deficit = G – T

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 Principles of Macroeconomics
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Assumption regarding Government Purchases and taxes are :

1. G or government expenditure is autonomous. It is fixed at all levels of national income or GDP.
2. T or tax rates are autonomous. Tax rate does not change with changes in GDP. As GDP rises,
given the tax rate, tax revenue rises (see table below).
Budget Surplus Function
GDP Government Net Taxes Government
Expenditure (T = 0.1 Y) Surplus = T - G
0 80 0 -80
100 80 10 -70
500 80 50 -30
800 80 80 Zero
1000 80 100 20
1200 80 120 40
o Result: The table shows that budget surplus (or public saving) (T-G) is negative at low levels
of GDP and positive at high levels of GDP. The budget surplus is graphically shown in figure
below.

T-G = It is the budget surplus function.

Budget surplus is negative initially, then
becomes zero and then positive as
national income rises. The slope of
budget surplus function is the rate of
tax (which is 0.1 in figure)

Budget Surplus Function

o Disposable Income (YD) is the net income available for spending by households after
they receive transfer from a pay to the government. It thus consists of income plus
transfer minus Taxes, Y + TR – TA.
o Fiscal policy is the policy of the government with regards to the level of government
purchases, the level of transfers, and tax structure.
We assume that the government purchases a constant amount, G; that it makes
a constant amount of transfers, T̅R̅; and that it imposes a proportional income tax,
collecting a fraction , t, of income in the form of taxes:
G = G̅ TR = T̅R̅ TA = tY …[1]
Since Tax Collection, and therefore YD, C, and AD, depends on the tax rate t, the
multiplier depends on the tax rate as we will see below.
With this specification of fiscal policy, we can rewrite the consumption function. after
substituting from equation (1) for TR and TA in earlier equation.
C = C̅ + cY
C = C̅ + c(Y+ T̅R̅ – tY)
= C̅ + cT̅R̅ + c (1-t) Y …[2]

Note in equation (2) that the presence of transfers raises autonomous consumption
spending by the marginal propensity to consume out of disposable income, c. times

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the amount of transfers." income taxes, by contrast, lower consumption spending at

each level of income. That reduction arises because households' consumption is
related to disposable income rather than income itself, and income taxes reduce
disposable income relative to the level of income.

While the marginal propensity to consume out of disposable income remains e, the
marginal propensity to consume out of income is now c(1 - t), where 1- t is the fraction
of income left after taxes. For example, if the marginal propensity to consume, c. is .8
and the tax rate is .25, the marginal propensity to consume out of income, c(1-t), is
.6 [= .8 × ( 1 - .25)].
Combining the aggregate demand identity with equations (1) and (2), we have
AD = C + I + G + NX
= [C̅ + cT̅R̅ + c (1 – t) Y̅] + I̅ + G̅ + N̅X̅
= (C̅ + cT̅R̅ + I̅ + G̅ + NX̅) + c( 1- t ) Y
Y = AD = A + c( 1 – t ) Y
Where, A̅ = C̅ + cT̅R̅ + I̅ + G̅ + N̅X̅ …[3]

The slope of the AD schedule is flatter because households now must pay part of
every dollar of income in taxes and are left with only 1-r of that dollar. The marginal
propensity to consume out of income is now c (1-t) instead of c.

EQUILIBRIUM INCOME
We are now set to study income determination when the government is included.
We return to the equilibrium condition for the goods market, Y = AD, and using equation
(3), write the equilibrium condition as
Y = A̅ + c (1-t) Y
We can solve this equation for Y0, the equilibrium, level of income, by collecting
terms in Y:

….[4]

As per above equation, we see that the government sector makes a substantial difference. It
raises autonomous spending by the amount of government purchases, G̅, and by the amount
of induced spending out of net transfers, cT̅R̅ in addition, the presence of the income tax
lowers the multiplier.
INCOME TAXES AND THE MULTIPLIERS
o Income taxes lower the multiplier, as can be seen from equation (4). If the marginal
propensity to consume is .8 and taxes are zero, the multiplier is 5; with the same
marginal propensity to consume and a tax rate of .25, the multiplier is cut in half, to
1/[1 - .8 ( 1 - .25)] = 2.5. Income taxes reduce the multiplier because they reduce the
induced increase of consumption out of changes in income. The inclusion of taxes flat
tens the aggregate demand curve and reduces the multiplier.

INCOME TAXES AS AUTOMATIC STABILIZERS

o The proportional income tax is one example of the important concept of automatic
stabilizers. As you remember, an automatic stabilizer is any mechanism in the
economy that automatically i.e., without case-by-case government intervention

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reduces the amount by which output changes in response to a change in autonomous

demand.
o Change in investment demand have a smaller effect on output when automatic
stabilizers-such as a proportional income tax, which reduces the multiplier-are in place.
This means that in the presence of automatic stabilizers we should expect output to
fluctuate less than it would without them.
o Higher unemployment benefits and income tax rates in the post – World War II period
are reasons that the business cycle fluctuations have been less extreme since 1945
than they were earlier.

EFFECTS OF A CHANGE IN FISCAL POLICY

The effects of changes in fiscal policy on the equilibrium level of income. Consider a change
in government purchases. This case is illustrated in Fig. below, where the initial level of income
is Y0. An increase in government purchases is a change in autonomous spending. Therefore,
the increase shifts the aggregate demand schedule upward by an amount equal to the
increase in government purchases. At the initial level of output and income, the demand for
goods exceeds output and, accordingly, firms expand production until the new equilibrium, at
point E’, is reached. By how much does income expand? Recall that the change in equilibrium
income will equal the change in aggregate demand, or

ΔY0 = ΔG̅ + c(1 – t ) ΔY0 …[5]

where the remaining terms (C̅,T̅R̅ ,I̅ , N̅X̅) are constant by assumption. Thus, the Change in
the equilibrium income is

…[6]

Where we have introduced the notation αG to denote the multiplier in the presence of income
taxes:

…[7]
Thus, a $1 increase in government purchases will lead to an increase in income in excess of
a dollar. With a marginal propensity to consume of c = .8 and an income tax rate of t = .25, we
would have a multiplier of 2.5: A $1 increase in government spending raises equilibrium
income by $2.50.

THE EFFECT OF AN INCREASE IN GOVERNMENT PURCHASES

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 Principles of Macroeconomics
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o Suppose that instead of raising government spending on goods and services, G̅ the
government increases transfer payments, T̅R̅. Autonomous spending, A̅, will increase by
only cΔT̅R̅, so output will rise by αG x cΔT̅R̅. The multiplier for transfer payments is smaller
than that for government spending-by a factor c-because part of any increase in T̅R̅ is
saved.
o If the government raises marginal tax rates, two things happen. The direct effect is that
aggregate demand will be reduced since the increased taxes reduce disposable income
and therefore consumption. In addition, the multiplier will be smaller, so shocks will have
a smaller effect on aggregate demand.

The Budget

➢ Government budget deficits have been the norm in the United States since the 1960s.
This pattern was broken down for a short period during the second Clinton administration
when the U.S. government ran a budget surplus. Tax cuts in 2001 plus spending on the
second Gulf War put the federal budget back into serious deficit. In 2009, the fiscal
stimulus package generated a record peacetime deficit. Over the long sweep of history,
the federal government typically ran surpluses in peacetime and deficits during wars. In
contrast to the United States, several other countries have moved from deficit to surplus
as their budget norm. Canada is notable in this regard.
➢ The fear is that the government's borrowing makes it difficult for private firms to borrow
and invest and thus slows the economy's growth.

➢ The First important concept is the budget surplus, denoted by BS. The budget surplus is
the excess of the government's revenues, taxes, over its total expenditures, consisting of
purchases of goods and services and transfer payments:

BS = TA - G̅ - T̅R̅ …[8]
➢ A negative budget surplus, an excess of expenditure over revenues, is a budget deficit.
➢ Substituting in equation the assumption of a proportional income tax that yields tax
revenues TA = tY gives us

BS = tY - G̅ - T̅R̅ …[8a]

➢ The budget surplus as a function of the level of income for given G̅, T̅R̅, and
income tax rate, t. At low levels of income, the budget is in deficit (the surplus is
negative) because government spending, G̅ + T̅R̅, exceeds income tax collection.

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 Principles of Macroeconomics
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At high levels of income, by contrast, the budget shows a surplus, since income
tax collection exceeds expenditures in the form of government purchases and
transfers.
➢ The budget deficit depends not only on the government's policy choices, reflected
in the tax rate (t), purchases (G̅), and transfers (T̅R̅), but also on anything else that
shifts the level of income. For instance, suppose there is an increase in investment
demand that increases the level of output. Then the budget deficit will fall, or the
surplus will increase because tax revenues have risen. But the government has
done nothing that changed the deficit.

We should not be surprised to see budget deficits in recessions, periods when the
government's tax receipts are low. And in practice, transfer payments, through
unemployment benefits, also increase during recessions, even though we are taking
T̅R̅, as autonomous in our model.

The Budget Surplus

EFFECT OF GOVERNMENT PURCHASES AND TAX CHANGES ON THE BUDGET

SURPLUS
o Increased government purchases, from equation (8), are reflected in a reduced surplus
or an increased deficit. On further thought, however, the increased government purchases
will cause an increase (multi plied) in income and therefore increased income tax
collection. This raises the interesting possibility that tax collection might increase by more
than government purchases.
o A brief calculation shows that the first guess is right: Increased government purchases
reduce the budget surplus. From equation (6) we see that the change in income due to
increased government purchases is equal to ΔY0 = αGG̅. A fraction of that increase in

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 Principles of Macroeconomics
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income is collected in the form of taxes, so tax revenue increases by to αG ΔG̅. The change
in the budget surplus, using equation (7) to substitute for αG, is therefore
which is unambiguously negative.
We have therefore shown that an increase in government purchases will reduce the
budget surplus, although in this model by considerably less than the increase in
purchases. For instance, for c= .8 and t = 25. a $1 increase in government purchases will
create a $0.375 reduction in the surplus.
o We know that the increase in the tax rate will reduce the level of income. It might thus
appear that an increase in the tax rate, keeping the level of government spending
constant, could reduce the budget surplus. In fact, an increase in the tax rate increases
the budget surplus, despite the reduction in income that it causes

THE FULL-EMPLOYEMENT BUDGET SURPLUS

o The full-employment budget surplus measures the budget surplus at the full-
employment level of income or at potential output. Using Y* to denote the full-
employment level of income, we can write
BS* = tY* - G̅ - T̅R̅ …[10]
o To see the difference between the actual and the full-employment budgets, we sub tract
the actual budget surplus in equation (8a) from the full employment budget surplus in
equation (10) to obtain
BS* - BS = t (Y* - Y) …[11]
o The only difference arises from income tax collection. Specifically, if output is below 15
full employments, the full-employment surplus exceeds the actual surplus/ Conversely,
if actual output exceeds full-employment (or potential) output, the full-employment sur
plus is less than the actual surplus.
o In a recession the cyclical component tends to show a deficit, and in a boom, there may
even be a surplus.
o Government purchases and government transfer payments act like increases in
autonomous spending in their effects on the equilibrium level of income. A proportional
income tax has the same effect on the equilibrium level of income as a reduction in the
propensity to consume. A proportional income tax thus reduces the multiplier.