C OMPETITIVE E QUILIBRIUM

F ISCAL P OLICY

Intermediate Macroeconomics.
ECON 304
Prof. Elisa Belfiori
Colorado State University

These notes are based on Chapter 5 of the book. This is my

advise on how to use these slides:
1

Skim over them. You will not understand many concepts but
you will get an idea of what is covered in the chapter. You
will also have a sense of which parts of the chapter you need
to focus on and which ones you can read just for fun.

Read the chapter. Take your own notes on the most

important parts of it.

Get back to the lecture notes and complete them with your
personal notes. Make sure you understand every single bullet I
have included in here. If I wrote it in my notes, it means I
think it is important so you need to make sure you know and
understand it.

Enjoy !

Note: In this chapter, the book uses the idea of a social planner and introduces
a Production Possibility Frontier. You do not need to go over that. Instead,
our analysis here will take the form of demand and supply curves. Please read
the chapter to get a general feeling of the topic and to extract the intuition for
the results we derive. But follow the slides in terms of the approach taken.

Fiscal Policy
We want to use the model to study policy
Suppose we are in a recession
Suppose the government is planning to increase spending in
order to boost the economy
We call Government stimulus to short run increases in
government expenditures aimed at increasing output

What is the effect of this policy in the economy?

That is: How does this policy affect Consumption, Employment
and Output?

Taxes have to increase to finance the higher level of G (Since

G = T)

An increase in taxes ( T) is a negative income effect for

the consumers
1

The consumer feels poor, wants to consumer less of the two

goods he consumes: C `

Less `, implies more N s the Labor supply curve shifts to

the right
At the original wage, there is unemployment in the labor
market w decreases until the unemployment is gone

The overall effect of the increase in government expenditure is

N, Y, w, C
(The effect on consumption is actually ambiguous. To see that, note that
C=Y-G Y increases with an the increase in G. Since both go up,
consumption goes up if Y increases more than the increase in G. However,
evidence seems to show that the increase in Y is less than the one in G)

Graphically:

The take-away conclusion of this policy analysis is that:

There are some tradeoffs in using government spending to
boost the economy
1

The policy is effective: Output and employment increase

But people end up consuming less and working more for a

lower wage

Overall welfare decreases U (c, `) (people are less happy)

The American Recovery and Reinvestment Act

(ARRA) of 2009
The ARRA was a law signed by President Obama in Feb 2009
It responds to the idea that the government has to introduce
policies to increase output when it falls below trend (like in
the 2008-2009 recession)
We learn from our model that there are some tradeoffs in
introducing this policy (we may all end up worse-off with it!)
It is worth mentioning that we are neglecting some aspects of
the policy that we still need to address later in the class
1

The increase in G has implications also for the government

deficit and for how the deficit is financed

Government spending might be productive (roads, bridges)

what if G increases the national stock of capital or
productivity?

We will study those later since for now G = T (no deficit)

A productive Government Spending

Suppose that the government stimulus makes firms more

productive. For example, spending on roads lower the cost of
transportation or reduces the commuting time of workers, which
increase they productivity. That is, suppose there is an increase in
G which has associated an increase in z ( G and z)
What is the effect of this policy in the economy?
This means: How does this policy affect Consumption,
Employment and Output?

On the consumers side , the effect of this policy is basically the

same we just discussed
1

Taxes have to increase to finance the higher level of G (Since

G = T)

An increase in taxes ( T) is a negative income effect for

the consumers
1

The consumer feels poor, wants to consumer less of the two

goods he consumes: C `

Less `, implies more N s the Labor supply curve shifts to

the right

On top of that, on the firms side the increase in productivity (z)

means that:
1
Even with the same amount of workers, the firm can produce
more because it is overall more productive (maybe the
construction of roads by the gov allows workers to get to work
faster) the Production function shifts up
2

Each worker is more productive as well (the marginal

productivity of labor increases) the Labor demand
function shifts to the right

The overall effect of the increase in government expenditure is

N, Y, w, C (the effect on consumption is ambiguous)
(The effect on consumption is actually ambiguous. Again, C=Y-G but
now note that Y increases both due to the increase in G and due to the
increase in z. It is more likely now that overall Y increases more than the
increase in G, specially if the associated increase in productivity is large
enough)

Graphically:

The take-away conclusion of this policy analysis is that:

Most of the tradeoffs in using government spending to
boost the economy are gone if the increase in G is allocated
to productive uses
1

The policy is effective: Output and employment increase

People end up consuming more and working more but also

being paid more (higher wage)

Overall welfare increase U (c, `)

The lesson we draw from our model so far is that the effect of
government stimulus packages depend on how the gov spends
the money
1

If it is spent in unproductive uses (transfers, employing

unproductive workers in the government sector, etc), there are
trade-offs that may end up making americans worse off

If it is spent in productive uses (roads, bridges, public

transportation, etc), the stimulus can become a good policy to
boost the economy