Question

Question 2 Stimulate without more debt

Read ‘Stimulus, Without More Debt’ by Robert Shiller.

Assume the economy is in a recession. The government has a high level of debt and wants to

set a balanced budget, that is, G = T. How can the government achieve a fiscal stimulus effect

on GDP whilst keeping the budget balanced? To answer the question, take the following

steps:

 Show how this is possible in a multiplier diagram, ensuring that you label the relevant

intercepts and angles. Make the diagram sufficiently accurate so that the exact size of the

multiplier is visible.

 Explain in words how the government can achieve such a fiscal stimulus effect whilst

keeping the budget balanced.

 Derive the balanced budget multiplier using algebra. (Hint: You will need to write down

expressions for the change in GDP associated with a change in both G and T and set these

equal to each other.)

 Comment briefly on any disadvantages you see with the use of this balanced budget fiscal

stimulus.

Hint: You can make the following assumptions: Assume a lump sum tax. This means that the

tax does not depend on the level of income, T = ?ത, rather than our usual assumption

that T = tY. Also assume that the country does not have any imports or exports.

Answer 1

1. Balanced budget is a government budget when there is neither budget surplus nor budget deficit. The balanced budget multiplier is unity and reflected in the below graph with a slope of 1 (angle = 45 degree).

As shown in the graph, there is a fall in consumption from C1 to C2 due to increase in tax (tax receipts = DE). However, given autonomous investments and government expenditure, the aggregate C2 increases from OA to OB i.e., by AB.

2. For the Balanced Budget theory, the marginal propensity of consume is assumed to be same for government expenditure beneficiaries and tax payers. Inspite of balanced budget (no fiscal deficit), stimulus is possible due to role of MPC (marginal propensity of consume) in formula of Government expenditure multiplier (K_g) and Tax multiplier (K_t).

3. In light of the explanation in point 2) above, K_g + K_t = K_b = Balanced Budget Multiplier

Also, K_g and K_t are given by,

K_g = 1/1-MPC

K_t = -MPC / 1-MPC

Therefore, K_b = 1/(1-MPC) - MPC / (1-MPC)

=(1-MPC) / (1-MPC) = 1 (always unity irrespective of value of MPC)

4. The disadvantage of this model is the underlying assumption that MPC is same for beneficiaries of government expenditure and tax payers which may not be the real position. Further the growth comes directly from the tax payers.