The Government: Budget And The Economy

Public goods are the goods like roads, parks, police services, defence services, Railway, etc. These goods are collectively consumed by one and all people in the society. These Goods are produced and provided with welfare motive, which is the main objective of Government production.

So the public goods must be provided by the government due to following reasons –

•The benefits of public goods can be easily enjoyed by everyone.

•The consumption by one individual should not affect the consumption of another individual.

Therefore, providing public goods is responsibility of government due to non-rivalry and non-excludable reasons.

Fiscal deficit is the excess of total expenditure over total receipt. So the fiscal deficit estimates the borrowing requirements of the government from all the sources during the financial year. It is an estimate of borrowings by the government.

The greater will be the fiscal deficit the more will be the borrowings by the government. Higher borrowings imply a higher burden of repayment of loan and of interest on future generation.

Fiscal Deficit = Total expenditure - Total receipts (excluding borrowings)

Revenue deficit is the excess of revenue expenditure over revenue receipts whereas fiscal deficit is excess of total expenditure over total receipts (excluding borrowings). Fiscal deficit is a wider phenomenon than revenue receipts. If capital expenditure is greater than non-debt capital receipts then there is physical deficit even if there is no revenue deficit.

Given is –

I = 200

G = 150

T = 100

C = 100 + 0.75 Y

So, C (Autonomous consumption) = 100

And, MPC (c) = 0.75

(a) What is the level of equilibrium income?

Level of equilibrium income = 1/(1-c) [C - cT + I + G]

= 1/ (1 – 0.75) [100+ (0.75 x 100) + 200 + 150]

= 1/0.25 [375]

= 1500

(b) Calculate the value of the government expenditure multiplier and the tax multiplier.

Government expenditure multiplier ∆Y/ ∆G = 1/1-c

= 1/ 1- 0.75

= 1/0.25

= 4

Tax multiplier ∆Y/ ∆T = -c/1-c

= -0.75/0.25

= - 3

(c) If government expenditure increases by 200, find the change in equilibrium income.

New level of equilibrium income = 1/(1-c) [C - cT + I + G + ∆G], Where ∆G = 200

= 2300

Change in equilibrium income = 2300 – 1500 = 800

Given is

C = 20 + 0.80 Y (C = 20 & MPC = 0.8)

I = 30

c = 0.80

G = 50

TR = 100

(a) Equilibrium level of income = 1/(1-c) [C + cTR + I + G]

= 1/ (1 – 0.8) [ 20 + (0.8 X 100) + 30 + 50]

= 900

Autonomous expenditure multiplier = 1/1-c

= 1/1-0.8

= 5

(b) If government expenditure increases by 30, what is the impact on equilibrium income?

New level of equilibrium income = 1/(1-c) [C + cTR + I + G + ∆G], Where ∆G = 30

= 1050

Change in equilibrium income = 1050 – 900 = 150

c) Tax multiplier ∆Y/ ∆T = -c/1-c

= -0.8/0.2

= - 4

∆Y/ ∆T = - 4

∆Y = - 4 X ∆T

= - 4 X 30

= - 120

Y = 900 – 120 = 780

Given is

C = 20 + 0.80 Y (C = 20 & MPC = 0.8)

I = 30

c = 0.80

G = 50

TR = 100

∆TR = 10

(a) Equilibrium level of income = 1/(1-c) [C + cTR + I + G + c∆TR]

= 1/ (1 – 0.8) [20 + (0.8 X 100) + 30 + 50 + (0.8 x 10)]

= 940

∆Y = 940 – 900 = 40

Change in income due to change in tax

∆Y = -c/1-c X ∆T = - 40

Therefore increase in 10% in transfer will raise the income by 40% and increase in 10 % in tax will decrease the income by 40%

Given is

C = 70 + 0.70 YD

I = 90

G = 100

T = 0.10Y

Y = C + I +G

(a) Find the equilibrium income

Y = 70 + 0.70YD + 90 + 100

Y = 0.70YD + 260

Y = 260 + 0.70 (Y - T)

Y = 260 + 0.70Y - 0.70T

Y = 260 + 0.70Y - 0.70 × 0.10 Y

Y = 260 + 0.63Y

Y - 0.63Y = 260

Y = 260/0.37

Y = 702.7

(b) What are tax revenues at equilibrium income? Does the government have a balanced budget?

T = 0.10Y

= 0.10 X 702.7

= 70.27

This shows that Govt Expenditure is more than tax revenue, so it is not a balanced budget but a deficit budget

Given is

c = 0.75

t = 0.20

(a) Change in equilibrium income if Government purchases increase by 20

∆Y = [1/1-{c (1-t)}] X ∆G, where ∆G is 20

= [1/1 – {0.75X0.80}] X 20

= 50

(b) Change in equilibrium income if transfers increase by 20

∆Y = (c/1-c) X ∆T

= (0.75/1-0.75) X 20

= 60

The tax multiplier is smaller in absolute value than the government expenditure multiplier because the government expenditure affects the total expenditure and taxes through the multiplier.

The tax multiplier also influences the disposable income which affects the overall consumption level.

Let us explain it with the help of an example -

Suppose MPC (c) is 0.60

Government expenditure multiplier = 1/1-c

= 1/1-0.6

= 2.5

Tax multiplier = - c/1-c

= - 0.6 /1-0.6

= - 1.5

This shows that government expenditure multiplier is more than the tax multiplier.

In order to meet the government deficit, the government relies upon borrowings, which creates government debt. So the concept of deficit and debt are closely related. Deficit is a flow which adds to the stock of debt.

Public debt or government debt is the amount that the Central Government owes. This may be in form of borrowings from bank, public financial institutions, or from other internal and external sources.

The public debt definitely imposes a burden on the economy which is being discussed below –

a) To repay the debt, the government imposes higher tax or get the money printed, which adversely affects the productivity and investment.

b) The burden of debt is transferred to future generation which negatively affects the welfare of younger generation.

c) The government increases the rate of interest on bonds and securities to attract more investment due to which a major part of saving of citizens goes in the hands of government, which lower the private investment.

d) The wealth of the country is drained out in repayment of loan taken from foreign countries and institutions.

Fiscal deficit turns out to be inflationary in the government finances it by way of deficit financing. Deficit financing means that the government borrows from Reserve Bank of India. The government issues treasury bills against which the RBI gives cash to government and this increases money supply in the economy. Increase in money supply leads to increase in the general price level and a persistent increase in price level over a period of time. This increase culminates into an inflationary spiral, which is a wage price spiral. It means wages catching prices and prices catching wages in turn. It affects the process of growth of economy and raises the cost push inflation.

Therefore, the physical deficit should be carefully managed in an economy. If it is managed by increasing production it may not be inflationary.

The Government of India has been trying to reduce its deficit by

•Increase in taxes

•Reduction in its expenditure and

•Increase in its receipts through the sale of shares in Public Sector Units

However, these steps could result in deficit reduction, but the activities of government should be more efficient through proper planning of program along with better administration and implementation.

The alternative way of deficit reduction can be to change the scope of government by withdrawing it from some of the areas which were under its purview.

In discharging its fiscal responsibilities the government has to pursue prudent fiscal policy which is conducive to bring a high rate of economic growth in the economy.