One of Keynes’s main ideas in The General Theory of Employment, Interestand Money was that government fiscal policy should be used to stabilise the level of output and employment. Through changes in its expenditure and taxes, the government attempts to increase output and income and seeks to stabilize the ups and downs in the economy. In the process, fiscal policy creates a surplus (when total receipts exceed expenditure) or a deficit budget (when total expenditure exceed receipts) rather than a balanced budget (when expenditure equals receipts). In what follows, we study the effects of introducing the government sector in our earlier analysis of the determination of income. The government directly affects the level of equilibrium income in two specific ways – government purchases of goods and services (G) increase aggregate demand and taxes, and transfers affect the relation between income (Y) and disposable income (YD) – the income available for consumption and saving with the households. We take taxes first. We assume that the government imposes taxes that do not depend on income, called lump-sum taxes equal to T.

Changes in Government Expenditure

We consider the effects of increasing government purchases (G) keeping taxes constant. When G exceeds T, the government runs a deficit. Because G is a component of aggregate spending, planned aggregate expenditure will increase. The aggregate demand schedule shifts up to AD′ . At the initial level of output, demand exceeds supply and firms expand production. The new equilibrium is at E′ . The multiplier mechanism (described in Chapter 4) is in operation.

Changes in Taxes

We find that a cut in taxes increases disposable income (Y – T ) at each level of income. This shifts the aggregate expenditure schedule upwards by a fraction c of the decrease in taxes. Because a tax cut (increase) will cause an increase (reduction) in consumption and output, the tax multiplier is a negative multiplier. We find that the tax multiplier is smaller in absolute value compared to the government spending multiplier. This is because an increase in government spending directly affects total spending whereas taxes enter the multiplier process through their impact on disposable income, which influences household consumption (which is a part of total spending).


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