Source: Image of business cycle created by Kate Eskra, Image of Circular Flow Diagram created by Kate Eskra
Hi. Welcome to Macroeconomics. This is Kate. This tutorial is on Expenditure and Income Equations. As always, my key terms are in red, and examples are in green. In this tutorial, we'll look at what fiscal policy involves and how the government can use these policies to either expand or contract the economy. We'll identify the three ways that money is spent in the economy, and we'll use the expenditure approach to do that. You'll see from the expenditure equations and income equations how we can derive public savings and government savings. And when we use those, you'll see actually why our deficit tends to increase over time.
So let's start out with a definition of fiscal policy. It's typically policy set by a central government authority where spending by the government is adjusted to stabilize economic activity. The government also uses taxation as a policy to do the same. So we have two tools of fiscal policy-- government spending and taxation. So fiscal policy then is going to look at the policies in these two areas. And the government uses these two tools to stabilize our economy's movement through business cycles.
So as a reminder about business cycles, these are the movement of an economy through expansion, then peak, contraction, and trough over time. It's an assessment of our economic activity through time. So here's a reminder of what a business cycle looks like. And can see that expansion, peak, contraction, and trough, and then it would start over. It's really normal for the economy to go through periods of growth and contraction, but fiscal policy's goal is to make sure that expansions are not too rapid, experiencing a ton of inflation, and contractions are not too severe, ending up in major recessions or even depressions.
So let's talk about spending in the economy, and let's go back to the expenditure approach. If you remember the expenditure approach to calculating GDP or our economic activity, it's the approach that calculates our economic activity by adding up what people are spending in the economy. So this activity in the output market way back from our circular-flow diagram, or circular-flow model. If you can see here, all the money being spent is up at the top. And we're really just going to focus on domestic. So we're going to take the imports and exports and the rest the world out of this equation.
So we're going to be looking at movement up here in the output market on goods and services. So the expenditure approach than, calculated C, or consumer purchases, plus I, which is investment in capital, generally by businesses, plus G, government purchases. It also included X minus M, which was exports minus imports. But we're going to take that out of the equation for now, because we're just considering domestic.
So if we only consider domestic, then basically we're looking at three ways money is spent in our economy-- through our individual purchases, business investments, and government purchases. OK, so if we write that, Y is our GDP or economic activity, we get C plus I plus G.
Let's start by solving for I. I is investment. It's also the same as savings in an economy. So if we save for I, we get Y minus C minus G, and again, investment is the same thing as savings in an overall economy. If we do something here, if we add and subtract T, being the taxes collected-- we can do that. Then we get that Y minus C plus T, our public savings, and T minus G, our government savings. OK, we're going to come back to these in a little bit to show you the impact here on government savings in a few slides.
So savings then are defined as income that's not consumed or paid in the form of taxes. So here's the term investment for you, sometimes this term actually creates some confusion with students in economics. Because they assume that when they hear the word investment, they assume that it means things like investing in the stock market or portfolio investments. And actually, as you can see here in this key term, investment in economics is defined as money that is used on capital resources. So for businesses, this can be things like land, equipment, or buildings. For individuals, it can be things like homes. So it's not portfolio investment like with the purchase of stocks, bonds, and other wealth accumulation related investments.
OK, so going back to our government spending. So we know that our government spends money in the economy in a lot of areas, you know, national defense, education, health care, welfare programs, infrastructure-- those are just a few. The government's role in this whole equation of C plus I plus G, is if they want to stimulate the economy, they can actually spend more money in order to create jobs or give people money to spend. If they need to slow down an overheated economy where inflation is a concern, it can cut spending levels.
So now we have the tool of taxation. We know that all levels of government-- federal, state, and local-- collect taxes from us in order to fund their programs. Again, if they want to stimulate the economy, get it moving, they can cut taxes. Essentially that gives us more money to spend in the economy. If they need to slow it down, they can raise taxes to slow down our spending-- take money essentially out of our pockets.
OK, so again going back to this, considering only domestic, we had these two things here of public savings and government savings. During recessions, government spending really should be greater than taxation, right? So during recessions where I was just talking about how the government wants to perhaps cut taxes and give us more money, but at the same time, they could also be increasing government spending by creating more programs and giving people more money to spend.
You can see why the term T minus G, then, is going to be negative if government spending is greater than taxation. So what happens to government savings during recessions? Well, it would be negative. OK? So instead of having savings, they would be in debt or running a deficit. That's what a deficit is.
In expansions, in theory, T then should be greater than G to offset these deficits that we have incurred during the recession. Once we recover, taxes should be increased again and/or government spending programs should be cut down. It should be-- that's the key word here. But you can see that this is politically difficult. Once you cut people's taxes, it is never popular to raise them again. Once you create government programs, it is not popular to eliminate them. So this is really difficult. So in reality, it's kind of easy, when we look at these terms this way, to see why our government deficit has grown so much over the years.
So in this tutorial, we talked about how fiscal policy involves both taxation and spending, and those can be used to either expand or contract our economy. And we looked at how consumer purchases, investment purchases, and government purchasing are the three ways that money is spent in the economy if we use our expenditure approach to calculating GDP. We saw that we can derive public savings and government savings from the expenditure and income equations. And when we look at those equations, I just showed you how it's easy to see politically why our deficit tends to increase over time so much. Thanks so much for listening. Have a great day.