Question

In 2015 , the Canadian government intended to adopt a balance budget act requiring the government to maintain a balanced budget at all times. Hence, if the government wishes to change government spending, it will always have to change the taxes by the same amount, that is, \(\Delta G=\Delta T\). Does this law imply that the government can no longer use fiscal policy to affect employment and output? (Hint: Analyze a "balanced-budget" increase in government spending, one that is accompanied by an equal tax hike.)

Short answer

Yes, the government can still use fiscal policy to affect employment and output under a balanced-budget act, because a balanced-budget increase in government spending, even with a tax hike, will increase aggregate demand due to the multiplier effect, hence influencing employment and output.

Step-by-step solution

Define Fiscal Policy

Fiscal policy refers to the use of government spending and tax policies to influence economic conditions, including demand, employment, and inflation. A balanced-budget law mandates that any increase in government spending \(\Delta G\) must be accompanied by an equivalent increase in taxes \(\Delta T\).

Analyze the 'Balanced-Budget' Multiplier

Consider what happens when there's an increase in government spending that is matched by an increase in taxes. The government spending increases aggregate demand directly, while the increase in taxes would typically decrease aggregate demand. However, the marginal propensity to consume (MPC) is less than 1, meaning that not all of the income is spent. Thus, the reduction in demand due to higher taxes is less than the increase in demand from higher government spending.

Assess Impact on Employment and Output

Since the aggregate demand increases on a net basis due to the multiplier effect, employment and output will likely increase as well. Therefore, even with a balanced-budget amendment, the government can still use fiscal policy to affect employment and output.

Key concepts

Understanding Fiscal Policy

Fiscal policy is the government's approach to managing the economy by altering its spending levels and tax rates. Put simply, when the government decides to spend money on new projects or cut taxes, it stimulates economic activity. Conversely, when it cuts back on spending or raises taxes, it can slow down the economy. This tool is key to shaping economic conditions and is particularly important in times of economic downturns or booms.

In the scenario given, the Canadian government's decision to require a balanced budget means that increases in government spending must be matched by equal increases in taxes. This might seem like it would cancel out any potential impact on the economy. However, as the solution suggests, the net effect on aggregate demand—the total demand for goods and services in an economy—is crucial to understand here because it is not a simple one-for-one transaction.

Impact on Aggregate Demand

Aggregate demand (AD) represents the total amount of goods and services that all the different players in an economy (households, businesses, and the government) are willing and able to purchase at a given price level. It's an important concept because it helps us understand the overall demand in the economy.

When the government adopts a policy that increases spending (like building infrastructure), AD rises because more money is flowing into the economy. If this is done alongside an equal tax hike, one might assume that the increase in government spending is entirely offset by the decrease in household spending due to higher taxes. Yet, this isn't the case due to something economists call the 'marginal propensity to consume'.

The Multiplier Effect in Action

The multiplier effect is like an economic echo. When the government spends money, it doesn't just increase aggregate demand once. Instead, that initial spending is amplified as it moves through the economy. Here's how it works: the government pays a company for a service, that company then pays its employees, and those employees then spend their earnings on various goods and services. Each step in this chain creates further economic activity.

This multiplication of economic activity helps explain why a balanced-budget increase in government spending can still enhance employment and output. Due to the multiplier effect, even when taxes rise along with spending, the new government expenditures can generate additional rounds of spending that exceed the initial outlay.

Marginal Propensity to Consume and Its Role

Marginal Propensity to Consume (MPC) describes the portion of additional income that a household is likely to spend rather than save. It is a ratio between 0 and 1; if MPC is closer to 1, households spend most of their extra income. On the other hand, if it's closer to 0, they save more.

In the context of a balanced-budget fiscal policy, an increase in taxes decreases disposable income, but not all of it would have been spent anyway because MPC is less than 1. This difference means the initial government spending has more power in boosting aggregate demand than the dampening effect of the tax increase. Therefore, the government can still influence employment and output even with a balanced-budget policy.