Professor Steven Wood
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*Note: Reference to Professor Wood’s Power Point
Slides today will be noted as (18-1), for “Power
Point #18: Government Spending and its Financing
Part 1, Slide #1.”
Last week we talked about monetary policy, so this
week we will talk about fiscal policy. It’s important
to think about how fiscal policy and budget interact.
We’ll talk about fiscal policy and how it affects
budget balances, and we’ll also talk about
measuring budget change. Lastly, we will talk a bit
about effective short-run fiscal policy.
To start with, we need to think about couple of
things we’ve already learned. When we think about
government spending, we treat this as an exogenous
variable. We will keep doing this; in other words,
we’re not going to try to explain how much
government spending is taking place in terms of
other economic variables. There just isn’t any
consistent relationship. The Congress spends as
much as they want to spend.
Up to this point, tax has also been an exogenous
variable. But this will no longer be the case,
because most tax systems are actually income tax
systems. How much tax revenue is generated
depends on level of income. So the easiest way to
say that is that our tax revenue will equal tax rate
(“t”) multiplied with income (“Y”): T = tY. So we
will now make tax endogenous variable, and the tax
rate an exogenous variable.
If this is the case, then we can see that the budget
balance for the economy will equal:
T – G = tY – G
“tY” is also referred to as “induced budget; this
simply means that it depends on the level of
So it’s very clear then that if there is a change in Y,
T will change, and this also means that the budget
balance will change. Now all of a sudden, the
budget balance also becomes an endogenous
variable. If we were to graph this, it might look
something like this:
First, we have to recognize that in that equation, T-
G could be a positive number (if T is greater than
G) or a negative number (if G is greater than T) or
zero. On our horizontal axis, we want our economic
input. If income was zero, the budget balance would
be –G. This is as big as deficit can be. As income
grows, tax revenues will also rise, so the budget
balance will also improve. The slope of this line
equals the tax rate.
Needless to say, the higher the tax rate, the steeper