Question

3) Recent Conservative Party of Canada advertisements imply that Justin Trudeau has no understanding of economics because he can be quoted (out of context) as saying “the budget will balance itself”. Use the following general example of the Keynesian “Income-Expenditure” model (a.k.a. the “Keynesian Cross” in reference to the illustration of the aggregate expenditure equation “crossing” the 45 degree line (Y=Z)) to briefly explain how it may be possible that an increase in Government expenditure would result in enough of an increase in taxes collected to pay for itself and thus, how the budget might actually balance itself. Z = C + I + G C = c0 + c1(Y − T) I = ¯I T = t0 + tIY, 0 < tI < 1 G = G0

Answer 1

According to the classical economist, balanced budget situation arises when the government expenditure becomes equal to the taxes. That means, the increase in the national income will only be to the extent of increase in government expenditure (not by a multiplier effect), when the government expenditure and tax change by same amount.

When both the government expenditure & taxes increasing by same amount, the national income could increase only by the extent of increase in government expenditure. This in the Keynesian "Income-Expenditure" modelis referred to as balanced budget multiplier.

Balanced budget multiplier = Government budget multiplier + Tax multiplier

Balanced budget multiplier = (1/(1-MPC)) + (-MPC/(1-MPC)) = 1

Thus, suppose the initial level of national income is $ 100 million and let the government expenditure and tax increases by same amount , say $20 million, the end-effect would be that the national income would only increase by $20 million.

Explaining this phenomenon using Keynesian Cross:

Consider C₁ is the pre-tax initial consumption line. C₂ is the post-tax consumption line and DE is the the tax revenue. If the DE amount of tax revenue is government expenditure, the aggregate expenditure curve would be represented by C₂ + I + G, Assume the investment and government expenditure are given autonomous.

This curve intersects the 45° line at point F.

The national income rises from OA to OB with investment and government expenditure. It shall be noted that AB = DE = EF.

AB represents the increase in income (∆Y)

DE represent increase in tax (∆T) and

EF represent increase in government expenditure (∆G)

That means, ∆Y = ∆T = ∆G

Consider Balanced Budget Multiplier (BBM) given by K_B, where MPC is marginal propensity to consume - slope of the consumption function representing the change in consumption expenditure with change in national income.

K_G is positive and K_T is negative

The net effect of balanced budget is that national Income changes by an amount equal to a change in government expenditure.

So the value of BBM is 1.

Hence, Balanced Budget is said to occur.

In reality, since MPC is not same for all taxpayers and beneficiaries of government expenditure, BBM is less likely to be 1.

In most cases, it is less than 1 but greater than zero.