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ECON1102 Macroeconomics 1
ECON1102 Notes Chapter 5 - 8
Chapter 5: Government Sector and Fiscal Policy
Instruments of fiscal policy
 Government expenditure: current goods and services, investment and infrastructure
 Taxes (direct, indirect) – income taxes, consumption taxes (GST)
 Transfer payments – unemployment benefits, pensions
An increase in government spending has a larger effect on GDP than an exogenous tax cut
 The gov spending multiplier is larger than tax/transfer multiplier
 Taxes and transfer payments affect the level of disposable income (Y-T) received by the
private sector
 Exogenous changes in taxes and transfers only have an indirect effect on PAW
 If c is small it means the marginal propensity to consume is small

5
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2 – Government in the income-expenditure model
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Government decisions about G and T can affect the level of output in the economy
Assume a closed economy (X=M=0)
In the three-sector economy planned aggregate expenditure is:
o PAE = C + IP + G
o Where G represents government purchases of goods and services
In contrast to G, taxes T only affect PAE indirectly, thorough their effect on aggregate
consumption expenditure
o

C = C0 + c(Y-T)

(Y-T) is disposable income

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1 – tax function
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Many forms of taxation revenue will be positively related to the level of GDP
We assume that tax revenues are comprised of an autonomous or exogenous component T0
which is independent of national income, and of an induced or endogenous component which
depends on the level of Y and t= marginal tax rate 0o T = T0 + tY
We can think of t as the marginal tax rate in an economy
∆𝑇
=𝑡
o
∆}

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measures the change in tax revenues obtained from an addition dollar of national income
and is assumed 0marginal tax rate: indicates the change in tax revenues from a dollar change in national
income
the tax function can be substituted inot the consumption function to yield:
o C = C0 + c(Y-T)
o T = T0 + tY we substitute
o C = C0 + c(Y-T0 – tY) and rearrange to get
o C=C0 – cT0 + c(1-t)Y

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2 – equilibrium in three-sector model


Our model of the three-sector economy can be summarised by the following equations



Where we make the assumption that government expenditure is exogenous, along with
planned investment
Equilibrium in the model is given by: Y = PAE = C + IP + G and by substituting we get
PAE = [C0 – cT0 + I0 + G0] + c(1-t)Y
o Where the variables in [] brackets are the exogenous components of pAe and the
final term is the induced (or endogenous) component of PAE
Solving for equilibrium Y:

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o
o

Equilibrium GDP is equal to the first part of the above equations times total
autonomous expenditure
Allows us to calculate the effect of a change in government expenditure or a change
in autonomous taxes (or transfer) on equilibrium real GDP

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3 – government expenditure and tax multiplers
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Fiscal multipliers

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4 – balanced budget multipler
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Definition: government budget balance, BB = T – G
Consider equal changes in G and T so that (initial) level of budget surplus is unchanged
o Increase government spending by 100
o Increased exogenous taxes by 100
o Initial BB = T-G
o BB = (T+100)-(G+100)
o No change on initial value
o Will result in an overall increase in Y
In three sector model, BBM is positive but less than one in value

5
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5 – output gaps and fiscal policy
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

Potential GDP (Y*)
Output gap (Y-Y*)

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Y* = the level of real GDP produced if labour and capital inputs are utilised at their normal
rate
Income – expenditure model has no automatic mechanism to ensure Y = Y*
However, the model does imply exogenous changes in G and T can be used to close output
gaps
Increasing the tax rate t to eliminate a positive (expansionary) output gap
o PAE = [C0 – cT0 + I0 + G0] + c(1-t)Y
o The slope of the PAE curve is given by c(1-t) and depends on t, larger t gives rise to
a flatter PAE

5
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6 – automatic stabilizers


Automatic stabilisers
o Tendency for a system of taxes and transfers which are related to the level of
income to automatically reduce the size of GDP fluctuations
o System of taxes and transfer payments that act as automatic stabilisers for the
economy
o T = T0 + tY
o As GDP declines, the level of taxes falls and the level of transfer payments (e
...

unemployment benefits) will increase
o BB = (T-G) so fall in T, other things equal implies BB declines
o Process is automatic (without any government action) and makes contractions and
expansions in GDP smaller than they would have been otherwise

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7 – discretionary fiscal policy




Discretionary fiscal policy
o Refers to the deliberate changes in the level of government spending, transfer
payments or in tax rates
o Prior to 2007-08 global financial crisis (GFC), the importance of fiscal policy as
a (discretionary) policy instrument for stabilizing the economy has been
declining
o Fiscal policy was seen as less flexible and less timely than monetary policy
o Time lags with fiscal policy
 Recognition lag: recognize by monitoring the state of the economy – the
need for some form of policy action
 Decision lag – decide on an appropriate policy action
 Implementation lag – implementation of fiscal policy generally requires
legislation (needs to be approved by parliament)
 Effect lag: time required for policy to have a significant effect on economy
o Ideally macroeconomic policy should be forward-looking e
...
fiscal policy
changes made today should be designed to influence forecast of the future
What was different about GFC
o Falls in GDP were preceded by a financial/credit crisis
o Many countries (not Australia) have had relatively large and persistent falls in GDP
o Concerns about the ability of monetary policy to provide sufficient stimulus to
economics
...
3 – budget deficits and public debt


Budget balance (BB) = T-G
o Government purchases of goods and services = G
o Tax receipts (TA)

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o Transfer payments (TR)
o Interest payments on government debt (INT)
T = TA – TR – INT
Budget surplus/deficit is a flow variable
Budget deficits need to be financed in some manner
A standard source of financing is to borrow from the private sector
Public debt
o The outstanding stock of government borrowing is called public debt
o Public debt equals the sum of all past deficits less any surpluses
𝑫𝒕 = 𝑫𝒕–𝟏 − 𝑩𝑩𝒕
 D = stock )or level of public debt
 Dt = stock of debt at end of period t
 Dt-1 = stock of debt at end of period t-1
o for a given value of Dt-1
 a budget deficit BBt < 0, adds to the stock of debt, while
 a budget surplus BBt > 0 reduces the stock of public debt

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1 – government budget constraint
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government expenditures (transfer payments, purchases and interest payments) in any
period need to be funded by taxes or borrowing
a government can fund its outlays in three ways
o taxes
o borrowing
o printing money – last approach has bad reputation – associated with hyperinflation
assume government does not use money finance
means of relating government outlays (purchases, transfer and interest payments) to their
method of financing is via the budgeting constraint
budget balance: BBt = Tt - Gt
stock of debt: Dt = Dt-1 - BBt
-(Tt – Gt) = Dt – Dt-1
decompose T: Tt = Tt (line on top of t) – TRt – rDt-1
o Tt (with line on top) = tax receipts
o TRt = transfer payments
o rDt-1 = real interest payments on public debt
o r = real interest rate on debt
Gt + TRt + rDt-1 = Tt(with line) + Dt – Dt-1
o First part of equation is use of funds and
second part is funding sources
o G = government purchases
o Dt-1 = stock of government securities (i
...
public
debt) at the end of period (t-1) (or beginning of period t)
Budget constraints: trade offs
o In any period a government faces choices of how to pay for their expenditures
 One option is to raise just enough revenue through taxes and not borrow
...

 Raising taxes generally has economic costs and political consequences
...
3
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8% rather than 2%
o possible crowding out of private investment due to higher interest rates
 one mechanism by which higher public debt might act to reduce economic
growth is through crowding out
 closed economy NS and I model predicted an increase in the governemtn
deficit would tend to increase the real interest rate and reduce (crowd out)
the level of private investment

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

over time a persistently lower level of private investment would result in a
lower private capital stock in an economy and this could lead to a lower
level of real economic growth
o intergenerational equity
 borrowing because of deficit budgets can’t be sustained forever and
eventually surpluses would be required to reduce debt
 intergenerational equity means we should not enjoy the benefits of budget
deficits now and pass on the costs of those deficits to future generations
 as noted above, higher levels of public debt that are not matched by higher
levels of productive public infrastructure tend to be inequitable from an
intergenerational perspective
sustainability of public debt
o generally agreed that public debt should be sustainable
o we sue the GDP ratio
𝑫
𝒅=
𝒀
o growth in D relative to the growth in Y will cause d to rise and fall
o we can derive the following equation to describe the behaviour of the debt to GDP
ratio
(𝒓 − 𝒈)𝒅𝒕–𝟏
∆𝒅𝒕 =
− 𝒑𝒃𝒃 𝒕
𝟏+𝒈
 r = real interest rate on public debt
 g = growth rate of real GDP
 pbb = 𝑷𝑩𝑩
𝒀
 PBB = primary budget balance [Tt (with line) – Gt – TRt]
o Two factors act to increase debt to GDP ratio
 Primary budget deficits, i
...
pbb <0
 If real interest rate exceeds the growth rate of real GDP, i
...
r>g

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1 – Asset returns and price
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Asset prices and yields
o the yield or return on a financial asset is inversely related to the asset’s price
o return = price (tomorrow) + payoff / price (today)
o other things equal as price (today) increases, returns on assets decrease
bonds
o legally enforced promise to re-pay a debt, used by governments and businesses to
borrow money
o two forms: government (more interested in these) and corporate bonds
o elements of the bond
 term of bond = length of time before bond has to be repaid (terms can
range from 24 hours to 30 years) call maturity
 principal = amount that needs to be repaid at maturity
 coupon payment = regular dollar payment of interest on the bond
 coupon rate = coupon payment/principal
o bond prices and interest rates – inverse relationship
 bonds do not have to be held until maturity, but can bought and sold
(traded) on the bond market
 if market interest rates increase the bond price falls
o N period bonds general formula

o

Perpetuity ( no maturity date)

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e
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g
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Convertible to commodity on demand
o Fiat money: money has no intrinsic value (e
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currency or bank deposits)
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3 – Demand for money
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Moneys role as a medium of exchange is sufficient to generate a transactions demand for
money, other things equal, a higher value of transactions is expected to result in a higher
level of money holdings
What factors are likely to influence the quantity of money demanded from making
transactions
o Value of transactions (i
...
volume x price)
 real GDP (Y) as a proxy for volume of transactions -> other things equal, an
increase in Y will increase demand for money (M)
 aggregate price level (P) other things equal, an increase in P will increase
the demand for M
o (opportunity) cost of holding money
 money that is held to make transactions (currency and transactions
deposits) pays zero or low interest rate
 holding money incurs an opportunity cost, which is the nominal interest rate
you could have earned by holding a bond
 nominal interest rate (i) other things equal, and increase in i will reduce the
demand for M
o nominal interest rate (i)
 an increase in the nominal interest on non-monetary assets is expected to
result in a fall in the demand for money
 the % decrease in the demand for money in response to a 1% increase in the
nominal interest rate is called the interest elasticity of money demand
o price level (P)
 an increase in the price level P would be expected to lead to a proportional
increase in the demand for money (MD)
o real GDP (Y)
 other things equal, an increase in real GDP Y is expected to cause an
increase in the demand for money
 the percentage increase in the demand for money in response to a 1%
increase in real GDP is called the income elasticity of money demand

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equation and diagram

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financial innovation (and regulation)
o effects on composition of M
 tap and pay will reduce demand currency, but still need bank deposits for
transfer or to pay credit card account
 decline in currency and increase in deposits
o effects on demand of M
 transactions technology that is a substitute for M

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4
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4
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4
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4
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5 – money, prices and inflation
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Quantity theory is a long existing model linking the price level to the supply of money
o V = PY/M
o The definition of velocity can be re-arranged to give the quantity equation
o MxV=PxY
o This states that the money stock times velocity equals nominal GDP
Velocity
o How fast does a dollar circulate
o Value of transactions/money stock = nominal GDP/money stockQuantity equation

Chapter 7: Central banks and monetary policy
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Central banks
o Make operational decisions about monetary policy
o Often have a considerable degree of autonomy or independence in implementing
monetary policy
o Given the broad parameters by the government and then operate as they see fit
within the parameters
Targets and instruments
o Monetary policy: decisions and actions taken by the central bank to influence short
run macroeconomic outcomes
o Targets:
 inflation rate (1-3%)
 the level of resource utilisation (e
...
output gap or cyclical unemployment
rate
 Also concerned about financial stability
o CB’s do not have direct control over ultimate targets
o Instruments
 Monetary policy instrument: variable which the central bank can directly
control
 Eventually has a predictable effect on policy targets
o Most CBs currently use a (very) short—term interest rate as their policy instrument

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1
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1
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2 – monetary policy framework
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policy instrument (RBA)

transmission mechanism

targets

inflation, output

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statements by RBA indicate it has a flexible inflation target, takes output into account in
setting policy
an interest rate target is the instrument used by the RBA, also called the cash rate
o 11 monthly decisions on target cash rate per year, January left out and either raise,
lower or leave unchanged
o size of change is usually 25 basis points
o increasing cash rate = contractionary policy
o decreasing cash rate = expansionary policy

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1 – monetary policy decisions
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decisions about the direction of monetary policy are made on a monthly basis (except for
janurary) by the monetary policy board of the reserve bank
changes in the stance of moentary policy are implemented through changes in the cash rate
target
to tighten monetary policy, the RBA will raise the target value for the cash rate
to loosen the monetary policy, the RBA will lower the target value for the cashr ate

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2 – payment settlement and the cash market
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3
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cash is colloquial name for exchange settlement funds
in australia the settlement of payments between banks is done using accounts that are heldby
banks at the RBA
exchange settlement funds are held in accounts by Australian banks at the RBA
...
25% below its cash rate target, lower bound for actual cash rate
nd
2 automatic facilities

o

re discount rate (term not used by RBA): banks can at any time borrow cash (using
bonds as security) from the RBA at a rate that is 0
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2
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2
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2
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2
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3 – cash rate and the long term interest rates
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Under its current operating procedures, the RBA has little difficulty achieving its target for
the cash rate
However, the cash market is highly specialised and the cash rate is for very short term
borrowing and lending
Not clear how the cash rate is relevant to the consumption and investment decisions of
households and firms
...
3
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3
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4 – monetary policy rules
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Monetary policy rules
o What are the key influences on the value a central bank sets for its policy rate?
o Inflation and measure of resource utilisation (output gap) – variables/targets
o Monetary policy rules are simple models of the behaviour of central banks

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1 – Taylor rule
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Taylor rule is a model for central bank

o
o
o

If output gap negative, lower federal funds rate and vice versa
Indicates how central bank will respond to the level of inflation and output gap
Implies that central bank will increase its policy rate in response to higher inflation
and or an increasing output gap

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2 – simply policy rule
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Simplified policy reaction function
o In our future analysis, we will work with the following simplified policy
reactionfunction to describe central bank behaviour
o r = r0 + ypie
o we will assume the central bank automatically responds to changes in inflation by
changing the real policy rate (real cash rate)
o r0 and y are positive constants chosen by the RBA
o y indicates the sensitivity of the real cash rate to a change in inflation
o r0 indicates the value of the real interest rate when inflation is zero

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3 – a non-zero inflation target
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arbitrage
o while RBA targets a very short interest rate, changes in cash rate eventually lead to
changes in long term interest rates
o in practice market rates = cash rate + premium
o premium will tend to reflect risk or liquidity factors
 types of monetary policy
o endogenous or induced policy: we can think of the change in r to a change in
inflation as being an automatic policy response by the central bank
o exogenous or discretionary policy: this would be a change in r that is not due to a
change in inflation
Summary
 Banks hold ESA with RBA
 use ES accounts to settle or clear debts
 Funds held in ESA are called “cash”
 Banks can borrow and lend ES funds in cash market at cash rate
 RBA sets a target value for the cash rate
 Banks borrow and lend cash on short term basis, there is a market fro cash
 RBA intervenes in cash market
o Sets interest rates at which it will borrow and lend to banks
o Conducts open market operations with banks



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Title: ECON1102 Macroeconomics 1 chapter 5-7
Description: ECON1102 Macroeconomics 1 chapter 5-7 I studied these notes and attained straight A’s

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