Key Concepts

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Canadian governments directly buy about 25 percent of GDP according to the national accounts data. They also spend about 17 percent on transfer payments to persons and business, including interest payments to holders of government bonds.

Government expenditure G on goods and services, including the public services provided to households and business is a policy variable and an autonomous component of aggregate expenditure.

Net taxes (NT = tY), the revenue collected by government from households, are difference between taxes collected and transfers paid.

Disposable income is national income minus net taxes. Changes in disposable income cause changes in household consumption expenditure based on the MPC.

The net tax rate (t) reduces changes in disposable income relative to national income and reduces the marginal propensity to consume out of national income to c(1 − t). This lowers the slope of AE and the size of the multiplier.

Government expenditure and net taxes affect equilibrium national income by changing both autonomous expenditure and the multiplier.

The government budget describes what goods and services the government plans to buy during the coming year, what transfer payments it will make, and how it will pay for them. Most spending is financed by taxes, but some revenue comes from charges for services.

The government budget balance is the difference between net revenues and government expenditures. Because net tax revenues depend on national income (NT = tY) the actual budget balance is determined by the government’s budget plan and the level of national income. The actual budget balance will change with changes in national income.

Fiscal policy is the government’s use of its taxing and spending powers to affect aggregate demand and equilibrium GDP.

The structural budget balance (SBB) is an estimate of what the budget balance would be if the economy were operating at potential output. Changes in the structural budget balance are indicators of changes in fiscal policy because they measure changes in in expenditure and tax programs at a standardized income level.

The government’s tax and transfer programs are automatic (fiscal) stabilizers that reduce the size of the multiplier and the effects of transitory fluctuations in autonomous expenditures on equilibrium GDP.

Discretionary fiscal policies are changes in net tax rates and government’s expenditure intended to offset persistent autonomous expenditure shocks and stabilize aggregate demand and equilibrium output at potential output.

Public debt (PD) is the outstanding stock of government bonds issued to finance past government budget deficits minus the retirement of government bonds in times of past government budget surpluses. The annual change in the public debt is ∆PB = −BB.

Public debt ratio (PD/Y) is the ratio of outstanding government debt to GDP, PD/Y.

Recent sovereign debt crises in Portugal, Ireland, Greece and Spain provide clear examples of the difficulties high and rising public debt ratios cause.

The government sector and fiscal policy are important determinates of aggregate demand and equilibrium GDP. Government expenditures are an autonomous policy variable. Net tax rates and policy affect the size of the multiplier. Changes in government expenditure and tax programs through the setting of the government’s budget affect AE, AD and equilibrium GDP.