June 2009 Unit 2 Paper 2 - Question 4 Answers

4a iThe Balanced Budget Multiplier applies in the case where the increase in government expenditure of is exactly matched by an increase in taxation. In this situation, national income increases by the same magnitude, as the increase in government spending and taxation. The balanced budget multiplier is therefore equal to 1.

4a iiFiscal policy is the management of the economy through the level of government expenditure and taxation. That is, the government can use this demand management tool to achieve its macroeconomic objectives by manipulating the fiscal budget. Since it involves public spending and taxation, the arm of government which is in charge of this policy option is the Ministry of Finance.

4a iiiEvery year the government of a country announces it fiscal budget to be used over the upcoming twelve months. Sometimes the budget would be balanced which means that government spending is equal to government revenues in the form of taxation.

4a ivIn other instances, the budget would be unbalanced if its spending is not equal to its taxation revenue. If the government’s taxation revenue is less than the planned level of spending then it has a budget deficit. This deficit or shortfall of funds is called the public sector borrowing requirement (PSBR). This is also referred to as the public sector net cash requirement (PSNCR) which can be met by:Occasionally, government’s overall expenditure may be less than the amount of revenue it receives. In this case, the surplus could be used to repay debt that has accrued due to borrowing in previous years. Such repayment of government debt is commonly referred to as Public Sector Debt Repayment.

4bSuppose the government wants to spend an additional $20 billion on infrastructural improvements but wants to raise the money by increasing taxes by the same amount. In such a case the increase in government expenditure of $20 billion is exactly matched by an increase in autonomous taxation of $20 billion. In this situation, national income increases by the same magnitude, as the increase in government spending and taxation. That is, national income grows by $20 billion. This is known as the balance budget multiplier, which occurs whenever there are equal increases in both autonomous government spending and taxation. This scenario seems counter intuitive, as it would be expected that if both government spending and taxes increase, there would be no net injection into the economy and national income would be unchanged. The $20 billion tax imposed on households, increases withdrawals in the economy and hence lowers disposable income of households by this amount. If the MPC is 0.8, it means that only $16 billion is spent on consumer goods and services. Thus the impact of the increase in taxes is a decrease in consumption of $16 billion. Overall, the decrease in consumption of $16 billion and the increase in Government spending of $20 billion results in a net injection of $4 billion into the circular flow of income. The MPC of 0.8 implies that the multiplier is 5 [1/(1-0.8)], which means that the net injection of $4 billion results in an increase in national income of $20 billion ($4 billion x 5). Conclusively, although the government has a balanced budget, there is still a net injection into the

economy which results in an increase in the level of national income. Conclusively, since the increase in government expenditure of $20 billion coupled with an increase in taxation by this equivalent amount leads to an increase in national income by the same magnitude, the balanced budget multiplier is therefore equal to 1.

4ciIncreases in Government borrowing might lead to increases in the domestic rate of interest as the demand for finance goes up.

4ciiAs a result, the higher interest rate may discourage or ‘crowd out’ the potentially more efficient domestic private sector investment. To a large extent, private sector investments may make more efficient utilization of resources due to the existence of the profit motive, whilst public sector investments may lack such efficiency due to the existence of alternative Government objectives.

4ciiiGovernment spending financed by borrowing may result in inflationary consequences on the domestic economy. This type of inflation is known as ‘demand pull’.

4civThe repayment of interest and principal on external debt has to be made using foreign currency. This causes a significant drain of foreign exchange which negatively affects the balance of payment and the exchange rate.

4dAs the rate of interest increases, some private sector investment projects would become unfeasible. This is shown by the movement along the MEI curve (contraction) as the rate of interest increases from 8% to 15%. Overall, private sector investments decrease from $7M to $5M.

Investment

Rate of Interest

8%

$5M

MEI

15%

$7M

4eThe National Debt, also known as the public sector debt, is the accumulated debt built up by the government over a number of years that has not yet been repaid. Interest payments and the repayment of principal on debt is on burden from public debt. This is because it reduces the amount of money which the government has, to devote towards other uses such as spending on educational facilities for instance. This may also result in an increase in taxes which may not be favoured by taxpayers.