The government buys goods and services, and levies taxes (net of transfer
benefits) that reduce disposable income below national income and output.
Net taxes, if related to income levels, lower the marginal
propensity to consume out of national income. Households get only part of
each extra pound of national income to use as a disposable
income.
Higher government spending on goods and services raises
aggregate demand and equilibrium output. A higher tax rate
reduces aggregate demand and equilibrium output.
An equal initial increase in government spending and taxes raises aggregate
demand and output. This is the balanced budget multiplier.
The government budget is in deficit (surplus) if spending
is larger (smaller) than tax revenue. Higher government spending raises the
budget deficit. A higher tax rate reduces it.
In equilibrium in a closed economy, desired savings and taxes equal desired
investment and government spending. An excess of desired savings over desired
investment must be offset by an excess of government purchases over net tax
revenue.
The budget deficit is a poor indicator of fiscal stance.
Recessions make the budget go into deficit, booms generate a budget surplus.
The structural budget calculates whether the budget would
be in surplus or deficit if output were at potential output. It is also important
to inflation-adjust the deficit.
Automatic stabilizers reduce fluctuations in GDP by reducing
the multiplier. Leakages act as automatic stabilizers.
The government may also use active or discretionary fiscal policy to try
to stabilize output. In practice, active fiscal policy cannot stabilize
output perfectly.
Budget deficits add to the national debt. If the debt
is mainly owed to citizens of the country, interest payments are merely a
transfer within the economy. However, the national debt may be a burden if
the government is unable or unwilling to raise taxes to meet high interest
payments on a large national debt.
Deficits are not necessarily bad. Particularly in a recession, a move to
cut the deficit may lead output further away from potential output. But huge
deficits can create a vicious circle of extra borrowing, extra interest payments
and yet more borrowing.
In an open economy, exports are a source of demand for
domestic goods but imports are a leakage since they are a
demand for goods made abroad.
Exports are determined mainly by conditions abroad and can be viewed as
autonomous demand unrelated to domestic income. Imports are assumed to rise
with domestic income. The marginal propensity to import MPZ
tells us the fraction of each extra pound of national income that goes on
extra demand for imports.
Leakages to imports reduce the value of the multiplier
to 1/[1 - MPC' + MPZ].
Higher export demand raises domestic output and income. A higher marginal
propensity to import reduces domestic output and income.
The trade surplus, exports minus imports, is larger the
lower is output. Higher export demand raises the trade surplus, a higher marginal
propensity to import reduces it.
In equilibrium, desired leakages S + NT + Z must equal desired injections
G + I + X. Thus any surplus S - I desired by the private sector must
be offset by the sum of the government deficit G - NT and the desired
trade surplus (X - Z).
