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 lower output, the larger the trade surplus, exports minus imports. 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).
