ESCP Business School

MACROECONOMICS
SESSION 5
ECONOMIC POLICIES
ECONOMIC POLICIES

An economic policy is a course of action that is intended to influence or control the

behavior of the economy.
Economic policies are typically implemented and administered by the government.
Examples of economic policies include decisions made about government spending and
taxation, about the redistribution of income from rich to poor, and about the supply of
money.

Goals of economic policy

Economic growth: Economic growth means that the incomes of all consumers and firms
(after accounting for inflation) are increasing over time.

Full employment: The goal of full employment is that every member of the labor force who
wants to work is able to find work.

Price stability: The goal of price stability is to prevent increases in the general price level
known as inflation, as well as decreases in the general price level known as deflation.
FISCAL POLICY
FISCAL POLICY

Fiscal policy involves the use of government intervention (spending,

direct and indirect taxation and government borrowing etc) to affect
the level and growth of aggregate demand in the economy, output
and jobs.
 TOOLS

TAXES:
Taxation is required by any government in order to:
Main aim: Manage demand in the economy - to help meet the government’s macroeconomic
objectives
Other aims:
• Raise revenue - to finance government spending
• Change the distribution of income and wealth
• Address market failure and environmental targets – taxes may help correct market failures

This is the main tool through which the government collects money from the public.

The government collects money from the public through income taxes, sales taxes, and
other indirect taxes.

Without taxes, a government would have very little room to collect money from the public.
TAXATION AND AGGREGATE DEMAND
 TOOLS

GOVERNMENT EXPENDIATURE:
To ensure economic growth, the government needs to spend money on projects that
matter.
three main areas of government spending are:

• Transfer Payments - welfare payments made to benefit recipients such as state pensions
and other benefits
• Current Spending - spending on state-provided goods & services such as salary for
teachers or nurses etc
• Capital Spending - infrastructure spending such as spending on new roads, hospitals,
motorways and prisons
 GOV. EXPENDITURE
TOOLS

1) TAXATION.
2) Natural resources

3) DEFICIT FINANCING (later)

Deficit financing means generating funds to finance the deficit which results from excess of
expenditure over revenue.
The gap being covered by borrowing from the public by the sale of bonds or by printing new
money.
FISCAL POLICIES
THE KEY ROLE OF G

In France total public sector spending is approx 56,5% of GDP

(highest in EU & OCDE); Finland is 53,5 %; Italy 49,4 %; Germany
44,4 %; UK 39,7 % and Ireland 32,2 %; Euro zone 47,1%; EU
45%

By way of comparison USA is 37,9% %, Brasil around 40 %

Russia around 35 %, China about 25 %

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FISCAL POLICIES
PUBLIC SPENDING IN EUROPE

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Fiscal policies & Keynesian model (1)

Recessionary(deflationary) and Inflationary Gaps

 FISCAL POLICIES

If however an economy is already at or near full employment

fiscal policy boosts through increased spending or reduced
taxation will simply generate an inflationary gap and so
inflation.

On the other hand if an economy is already in an inflationary gap

situation a reduction in government spending and/or an increase
in taxation will create a reduction in ΣD which will reduce the
rate of inflation and eliminate the inflation if sufficiently
contractionary.

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 FISCAL POLICIES
COUNTERCYCLICAL STABILISATION POLICY

This is in fact the key to the Keynesian approach to discretionary

macroeconomic policy manipulation known as countercyclical
stabilisation policy.
The policy is described as discretionary as opposed to
automatic:
that is to say that the government takes a view of the economic
situation each year and devises a budget which is designed

– to generate stimulus in a recession (when an economy is in from full

employment); or
– to generate contraction in a boom (when they judge the economy to be
in an inflationary gap situation, that is to say when ΣD >Yf).

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 FISCAL POLICIES & KEYNESIAN MODEL (2)

In the simple Keynesian model the impact of government fiscal

policies can be readily estimated using multiplier analysis.

In an economy away from full employment, any increase in

government purchases of goods and services will have a direct
multiplier effect raising real output by significantly more than the
initial spending boost and so also raising employment.

The size of this multiplier will depend on the degree of openness of

the economy etc.

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THE MULTIPLIER EFFECT
DEFINITION
THE MULTIPLIER EFFECT

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THE MULTIPLIER EFFECT
INCREASE IN G OF $ 3 BILLION

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 THE MULTIPLIER EFFECT
INCREASE IN G OF $20 BILLION

Because each dollar spend by the government can raise

the aggregate demand for g & s by more than one
dollar, G are said to have a multiplier effect on AD

The multiplier effect acts as a positive feedback as

higher demand leads to higher income, which in turns
leads to even higher demand

One all these effects are added together, the total impact
on the quantity of g & s demanded can be much larger
than the initial impulse from from higher G

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THE MULTIPLIER EFFECT

This is known as the multiplier effect and it means

that an exogenous increase in ΣD can set in train a
sequence of further increases in consumer demand
which mean that the eventual increase in ΣD is
much greater than the initial increase.

However the process of demand expansion has a

limit, because at each stage of output expansion, as
firms pump out more incomes into the circular flow,
some part of the increase will be withdrawn from the
domestic circular flow in the form of taxes, imports
and of course consumer savings

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THE MULTIPLIER EFFECT
CALCULATION
 THE MULTIPLIER EFFECT

Hence, at each round of expansion the further boost to ΣD

is diminishing and the effect will eventually peter out and
the economy will reach a new circular flow equilibrium at
a level of output and income significantly in excess of the
initial boost to exogenous expenditure which brought it
about.

Mathematically, the multiplier effect can be conceptualised

as the rate of change of equilibrium income in the circular
flow in response to changes in any of the exogenous
components of ΣD.
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THE MULTIPLIER EFFECT
FORMULA

Marginal Propensity To consume (MPC)= the fraction

of extra income that a household consumes rather than
saves
Ex: MPC=3/4
– For every extra $ that a household earns, it spends $0,75 (3/4
of a dollar) and saves 0,25
To gauge the impact on AD of a change in G, we
follow the effects step-by-step
For the extra G of $100 billion, this increase in income
in turn raises C by MPCx$100bn, which in turn raises
the income of workers & owners of the firms. The
second increase raises C by MPCx(MPC x$100bn)…
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 THE MULTIPLIER EFFECT
FORMULA

• Change in G = $100bn
• First change in C = MPC x $100bn
• Second change in C = MPC2 x $100bn
• Third change in C = MPC3 x $100bn
• …

• Total change in demand= (1 + MPC + MPC2 + MPC3 +…)x$100bn = 𝟏𝟎𝟎 ∗ σ∞

𝒏=𝟎 𝑴𝑷𝑪
𝒏

• So the multiplier is

• Multiplier= 1 + MPC + MPC2 + MPC3 +…

• For -1<X<1 : σ∞ 𝒏
𝒏=𝟎 𝑿 = 1/(1-X)

• Here X=MPC so

• Multiplier=1/(1-MPC)=1/MPS

• If MPC=3/4, the multiplier = 4

• A larger MPC means a larger multiplier

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AN INCREASE IN GOVERNMENT PURCHASES
(KEYNESIAN CROSS)
AN INCREASE IN GOVERNMENT PURCHASES
FISCAL POLICIES

This fundamental policy insight from the simple Keynesian

model remains as valid today as ever.
However we are today aware of some pitfalls with the
approach which were not immediately obvious when
Keynesians first proposed and implemented countercyclical
stabilisation policy in the 1950s and 60s.
Example: Corona Crisis

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 THE MULTIPLIER EFFECT
FORMULA

• A larger MPC means a larger multiplier

• The multiplier arises because higher income induces
greater spending on consumption; with a larger MPC,
C responds more to a change in income
• The logic of the multiplier effect is not restricted to
changes in G. It applies to any event that alters
spending on any component of GDP: C, I, G, NX
• The multiplier is important because it shows how the
economy can amplify the impacts of changing in
spending

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LIMITATIONS OF SIMPLE MULTIPLIER
ANALYSIS
 THE LIMITATIONS

There are two major limitations to multiplier analysis:

1. First of all there is the fact that it relates to an
economy in which there is spare capacity and away
from full employment; and where as a result it can be
presumed as an approximation that all reactions to
disequilibrium will be concentrated on real quantity
variables rather than in price changes.

2. Secondly the functional relationships used are very

simplified and in reality the macroeconomic
interactions are much more complex.

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 FUNCTIONAL COMPLEXITY
OVERSIMPLIFICATION OF KEYNES

The second major limitation of the Keynesian

model is the oversimplification inherent in the treatment
of the functional relationships governing the various
components of ΣD.
This can be particularly dangerous if the model is used
uncritically as a basis to justify simplistic policy
prescriptions.
The aggregate consumption function is simplified as we
know to
C = a(1-t)Y + b

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FUNCTIONAL COMPLEXITY
OVERSIMPLIFICATION OF KEYNES

This suggests that at least in the short run the decision of

how much to consume and how much to save depends
exclusively on consumer income when in fact a person’s
overall wealth, their expectations of the future, their age
and the prevailing conditions of consumer credit all also
have an influence.

Extensive empirical testing of aggregate consumption

functions has been carried out since the time of Keynes
and this corroborates a more complex picture

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Multiplier and an open Economy

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 THE MULTIPLIER EFFECT
FORMULA 2

In circular flow equilibrium we know that

• Y = C + I + G + X – Im
• C = a(1-t)Y + b
• T = tY
𝒅𝑰𝒎
• Im = f(Y); and let =μ
𝒅𝒀
Hence at equilibrium

• Y = a(1-t)Y + b + I + G + X –μY
• Y - a(1-t)Y +μY = b + I + G + X
• Y [1 – a(1-t) +μ] = b + I + G + X

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THE MULTIPLIER EFFECT
FORMULA 2

Therefore at equilibrium
𝒃+𝑰+𝑮+𝑿
Y=
[𝟏−𝒂 𝟏−𝒕 +𝝁]

And, if we differentiate the equilibrium condition

with respect to any one of the exogenous constant
expenditure terms in the numerator to assess the size
of the multiplier effect, we get for example

𝒅𝒀 𝟏
=
𝒅𝑮 [𝟏−𝒂 𝟏−𝒕 +𝜇]

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 THE MULTIPLIER EFFECT
FORMULA 2

It is interesting to consider typical values for

multipliers
• In a closed economy where a= 0,8; t = 0,4; μ = 0
𝒅𝒀 𝟏 1
• = = = 1,92
𝒅𝑮 [𝟏−𝒂 𝟏−𝒕 ] 0,52
𝒅𝑰𝒎
• In a moderately open economy where =μ = 0,2
𝒅𝒀
𝒅𝒀 𝟏 1
• = = = 1,39
𝒅𝑮 [𝟏−𝒂 𝟏−𝒕 +μ] 0,72
𝒅𝑰𝒎
• In a very open economy where =μ= 0,4
𝒅𝒀
𝒅𝒀 𝟏 1
• = = = 1,09
𝒅𝑮 [𝟏−𝒂 𝟏−𝒕 +μ] 0,92

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THE MULTIPLIER EFFECT
FORMULA 2

It can be shown readily enough from the alternate

version of the equilibrium condition
Σwithdrawals = Σinjections
S + T + Im = I + G + X
that since it is logically impossible that the sum of
withdrawals should be greater than total income
hence it must always be the case that
Σwithdrawals < Y
From which it can be shown that
[𝟏 − 𝒂 𝟏 − 𝒕 + 𝛍] < 1

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THE MULTIPLIER EFFECT
FORMULA 2

Hence the value of the multiplier will always be

in excess of 1, i.e. there will always be some
multiplier effect even if in very open economies
the effect may be quite small.

𝒅𝒀 𝟏
= >1
𝒅𝑮 [𝟏−𝒂 𝟏−𝒕 +μ]

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MPS= Marginal propensity to
save, MRT=MPT= Marginal rate
of taxation, MPM= marginal
propensity to import

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THE MULTIPLIER EFFECT
FORMULA 2

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