Prepared by Dr. Zhang Jianlin.

Copyright: Singapore Institute of Management Page 1

Macro 3: Closed Economy with Government


The government in an economy provides public goods and services (e.g. public infrastructures
and defense, etc.) that the private sector would either under produce or not produce at all. The
government also redistributes resources among households and firms.

These activities can be financed either by levying taxes on households and firms, or by issuing
debt, or by creating new money.

For the purpose of this topic, we focus on two government activities. The first is raising tax
revenues from households and firms. The amount of tax revenue raise is denoted as T. The
second activity is spending on the provision of public goods and services. The size of this
activity is denoted as G.


1. Some Terminologies

a. Budget Deficit: T < G

If the government spending is more than the taxes revenue collected, we say that the
government is running a Budget Deficit.

b. Budget Surplus: T > G

If the government spending is less than the taxes revenue collected, we say that the
government is running a Budget Surplus.

c. Budget Balance: T = G.

When the government spending exactly equals to the taxes revenue collected.

d. Fiscal Policies: the governments policies on G and T.

Fiscal Policies can be expansionary if the impact of the policies increase aggregate
demand.
E C I G = + +



Fiscal Policies can be contractionary if the impact of the policies decreases aggregate
demand.
E C I G = + +


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2. Implication to National Accounts

On NNP: The usages of national output include public consumption, denoted by G, as
well as private consumption and investment. That is

NNP = C + I + G

On Y: National income will be divided between taxes (T), consumption and savings. That
is
Y = C + S + T

As NNP = Y, i.e., we have
C + I + G = C + S + T
or, I = S + (T - G)


Exercise:
Interpret the above using economic intuition.



3. Impact of Government on Individual Consumption

With the government imposing income tax on households, consumption decision will be
based on disposable income (Yd), rather than the national income Y.

The disposable income is the difference between national income and tax, i.e.,

Yd = Y - T

Demand for consumption is thus:

C = C0 + c1(Y T)

4. System of Income Tax

Lump sum tax: T = T0, taxes are raised with no reference to income; all individual pay the
same amount of tax, regardless of their level of income.

Proportional tax: T(Y) = tY, there is a flat rate of tax which is paid by everyone regardless
of level of individual income.

Progressive tax: T(Y) = t(Y)Y, where the rate of tax depends on the income earned. It will
be progressive if the rate of tax increases with income, regressive if rate of tax decreases
with income.
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For the purpose of this course, we do not need to consider progressive tax.


5. Public Consumption/Government Spending (G)

There are various rules the government can use to guide its spending decisions. For example,

The governments expenditure can be positively related to national income, i.e.,

G(Y) = G0 + g1Y, for 0 < g1 < 1; g1 is the public marginal propensity to consume.

The governments expenditure can be negatively related to national income, i.e.,

G(Y) = G0 g1Y, for 0 < g1 < 1; g1 is the public marginal propensity to consume.

The governments expenditure can be independent of national income, i.e.,

G = G0

The government can run a budget balance. Depending on the tax system, it could either
be
G = T0 Or G = tY

6. Implication of different tax systems on effective MPC and MPS

With a lump-sum tax system, a unit increase in income will be used for consumption and
saving purposes.


Y increase by 1 unit



With a proportional tax system, the same unit increase in income will lead to an increase in
tax by t unit. The income after tax, (1 t), will be used for consumption and saving
respectively.



Y increase by 1 unit





Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 4



7. Aggregated Demand

Assuming G = G0 and T = T0, the aggregated demand for the economy can be written
as:

E(Y, r) = C(Y, T) + I(r) + G

As C =C0 + c1(Y T0), I (r) =I0 - I1r and G = G0

E(Y, r) = C0 + c1(Y T0) + I0 - I1r + G0
= [C0 - c1T0 + G0 + I0 - I1r] + c1Y

The autonomous component of demand contains government spending G0 and the effect of
lump-sum taxes on consumption, c1T0.

We can also write the aggregate demand function as: E(Y, r) = A(T0,G0, r) + c1Y

The complete picture for closed economy with government can be shown in the following
diagram.
Y
0
C
45

E C I G = + +
( ) S T G +
, , E C S
0 1 0
I I I r =
0
Y
1
Y


8. Characterization the multiplier with government

Assuming G = G0 and T = T0, the aggregate demand for the economy is

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 5

E(Y, r) = C(Y) + I(r) + G

As C =C0 + c1(Y T0), I(r) =I0 - I1r and G = G0

E(Y, r) = C0 + c1(Y T0) + I0 - I1r + G0 = [C0 - c1T0 + G0 + I0 - I1r] + c1Y

This can be written as E(Y, r) = A(T0, G0 , r) + c1Y

At equilibrium, E(Y, r ) = Y. This means A(T0, G0 , r)+ c1Y = Y

Hence,
0 0
1
1
( , , )
1
Y A T G r
c
=

and
1
1
1
c
is the multiplier.

As 1
1
1
1
>
c
, if we have a slight change in A, there will be a greater change in the
equilibrium level of Y. This is called Multiplier Effect.

Notice that the autonomous component A(T0, G0 , r) is now a function of interest rate,
government spending and taxes. Given that the economy's multiplier is greater than 1,
fiscal policies (government policy on G and T) that increase the autonomous component
of demand will increase output. This is main idea of the Keynesian model.

Exercise:
a) Show an increase in the government spending by 1 unit will increase output by
1
1
1 c
units.





b) Show an increase in the tax by 1 unit will decrease output by
1
1
1
c
c
unit.






c) Show the net impact on the equilibrium output following an increase in government spending
of G and a simultaneous increase in tax of T when G = T.





Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 6


Exercise:
Derive the multiplier in an economy with a proportional tax system assuming G = G0. Compare
the size of the multipliers under a lump-sum tax system and under a proportional tax system.












Example:
Here is a model of a closed economy:
C(Yd ) = 80 + 0.8 Yd ; I(r0) = 100 (short form of writing I =I0 I1r); G = 100 where Yd is
disposable income. Consider two tax systems (and a balanced budget policy); a lump-sum tax (G
= T0) and a proportional tax (G = T(Y) = tY). Will the equilibrium level of output be different
under the two tax systems? What will be the level of it?

Solutions:
We assume that Government collects same level of tax under two systems, further, there is a
government budget balance under both system. i.e., tax collected is just enough to pay for
government spending. Specifically,

Lump-sum tax: G = T0
Proportional tax: G = tY

In the case of lump-sum tax system, the aggregate demand of the economy is,

E(Y, r) = C(Y, T) + I(r0)+G

C =C0 + c1(Y T0); I(r0) = I0(r0) and G = G0
Thus,
E(Y0, r0) = C0 + c1(Y T0 )+ I0(r0) + G0
= [C0 - c1T0 + G0 + I0(r0)]+ c1Y

At equilibrium, E(Y, r0) = Y

So, [C0 - c1T0 + G0 + I0(r0)]+ c1Y = Y

Hence, Y = [C0 - c1T0 + G0 + I0(r0)]
1
1
1
c
with
1
1
1
c
is the multiplier.
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As, G = T = 100,

Y = [C0 - c1T0 + G0 + I0(r0)]
1
1
1
c
= [80 0.8 100 + 100 + 100]
8 . 0 1
1

= 1000


In the case of proportional tax system, the aggregate demand of the economy is,

E(Y, r0) = C(Y, T) + I(r0)+G

C =C0 + c1(Y tY); I(r0) = I(r0) and G = G0
Thus,
E(Y, r0) = C0 + c1(Y tY)+ I(r0) + G0
= [C0 + G0 + I(r0)] c1tY + c1 Y
= [C0 + G0 + I(r0)] + c1(1 t ) Y

At equilibrium, E(Y, r0) = Y

So [C0 + G0 + I(r0)] + c1(1 t ) Y = Y

Hence, Y = [C0 + G0 + I(r0)]
) 1 ( 1
1
1
t c
with
) 1 ( 1
1
1
t c
is the multiplier.

[C0 + G0 + I(r0)] = 80 + 100 + 100 = 280

But t is not given. However, we know that T = G = tY, so, t = G/Y

The economys multiplier is thus,
) 1 ( 1
1
1
t c
=
1
1
1 (1 )
G
c
Y

=
1
100
1 0.8(1 )
Y


So, Y = 280
1
100
1 0.8(1 )
Y


Solving the above, Y = 1000.

In this economic system, the government sets t and adjusts G to be equal to tY. It is easy to
establish that there is a rate of tax, t = 10%, which will yield exactly the same equilibrium as
before, Y = 1000.

For any t > 10%, equilibrium will be at a lower level of output, while for any t < 10%,
equilibrium level of output will be greater than 1000



Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 8


Homework

1. The effective marginal propensity to save is independent of whether there are lump-sum or
proportional taxes. True or false? Explain.

2. The effective marginal propensity to consume and the effective marginal propensity to save
add up to 1 only when there is a lump sum tax. True or false? Explain.

3. Derive the multiplier in an economy with a lump-sum tax system when the government
spending increases with national income.

4. Derive the multiplier in an economy with a proportional tax system when the government
spending increases with national income.

5. Compare the size of multipliers in question 3 and 4.

6. Assuming a lump sum tax system, find the multiplier of an economy where the poor (who get
the fraction of national income) do not pay tax but have the same marginal propensity to
consume as the rich. If there is a transfer of income from the rich to the poor, will there be
any effect on the multiplier.

7. A closed economy with the poor earning the fraction of national income. They do not
pay tax but have higher marginal propensity to consume than the rich. Assuming a lump
sum tax system, how would a transfer of income from the rich to the poor affect the
economy if wages and prices are fixed.