The Govt. and Fiscal Policy| Economics |CBCS

Fiscal policy 

It refers to the government’s spending and taxing behavior—in other words, its budget policy.

(The word fiscal comes from the root fisc, which refers to the “treasury” of a government.)

Fiscal policy is generally divided into three categories: 

(1) policies concerning government purchases of goods and services

(2) policies concerning taxes

(3) policies concerning transfer payments (such as unemployment compensation, Social Security benefits, welfare payments, and veterans’ benefits) to households. 

Monetary policy  refers to the behavior of the nation’s central bank, the Federal Reserve, concerning the

nation’s money supply.

Government in the Economy

discretionary fiscal policy-

Changes in taxes or spending that are the result of deliberate changes in government policy.

Government Purchases (G), Net Taxes (T), and Disposable Income (Yd) – 

Net taxes (T ) 

Taxes paid by firms and households to the government minus transfer payments made to households by the government.

Disposable, or after-tax, income (Yd) Total income minus net taxes: Y - T.

Yd excludes taxes paid by households and includes transfer payments made to households by the

government.

For now, we are assuming that T does not depend on Y—that is, net taxes do not

depend on income. 

Taxes that do not depend on income are sometimes called lump-sum taxes.

Since, the Figure shows, the disposable income (Yd) of households must end up as either con-

sumption (C) or saving (S). Thus,

This equation is an identity—something that is always true.

Because disposable income is aggregate income (Y) minus net taxes (T), we can write

another identity:

By adding T to both sides:

This explains that aggregate income gets cut into three pieces. 

Government takes a slice (net taxes, T), and then households divide the rest between consumption (C) and saving (S).

Because governments spend money on goods and services, we need to expand our definition of planned aggregate expenditure. Planned aggregate expenditure (AE) is the sum of consumption spending by households (C), planned investment by business firms (I), and government purchases of goods and services (G).

Now, A government’s budget deficit is the difference between what it spends (G) and what it collects in taxes (T) in a given period:

If G exceeds T, the government must borrow from the public to finance the deficit. It does soby selling Treasury bonds and bills. In this case, a part of household saving (S) goes to the government. 

If G is less than T, which means that the government is spending less than it is collecting in taxes, the government is running a surplus. A budget surplus is simply a negative budget deficit.

Adding Taxes to the Consumption Function

If you earn a million dollars but have to pay $950,000 in taxes, you have no more disposable income than someone who earns only $50,000 but pays no taxes. What you have available for spending on current consumption is your disposable income, not your before-tax income.

To modify our aggregate consumption function to incorporate disposable income instead of before-tax income, instead of C = a + bY, we write

Our consumption function now has consumption depending on disposable income instead of

before-tax income.

Planned Investment- 

The government can affect investment behavior through its tax treatment of depreciation and other tax policies. Investment may

also vary with economic conditions and interest rates.

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