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Prepared by Apostolos SerletisUniversity of Calgary


C h a p t e r 1 2Government Expenditure


Data on Government Expenditure

• Government expenditure is the dollar amount spent at all levels of government for purchases of goods and services, transfer payments (amounts given to households and businesses), and interest payments.


Just How Much Bigger is Government in Canada?


The Government’s Budget Constraint

• Gt represents government purchases in real terms for year t. Ct + It + Gt, is the aggregate real spending on goods and

services in year t.

• Vt represent the government’s real expenditure on transfers.

• The real revenue from money creation for year t is (Mt −Mt−1)/Pt

• Tt is the total real taxes collected by the government in year t. We assume that there is no public debt in the model, Bt = 0.



• Government budget constraint:

total uses of funds = total sources of funds

Gt + Vt = Tt + (Mt− Mt−1)/Pt

(real purchases + real transfers

= real taxes + real revenue from money creation)



• Government budget constraint

Gt + Vt = Tt

(real purchases + real transfers = real taxes)


Public Production

• We are assuming that the government subcontracts all of its production to the private sector.

• Public investment, publicly owned capital, and government employment are zero.


Public Services

• Begin with the hypothetical case in which public services have zero effect on utility and production.


The Household’s Budget Constraint

• Household budget constraint (with π = 0)C + (1/P)·∆B+∆K = (w/P)·Ls+ i·( B/P+K)

Ct + (1/P)·∆Bt+∆Kt

= (w/P)t·Lst + rt−1·(Bt−1/P + Kt−1)

• With Government (with π = 0)Ct + (1/P)·∆Bt+∆Kt

= (w/P)t·Lst + rt−1·( Bt−1/P + Kt−1) +Vt − Tt


The Household’s Budget Constraint

• Multiyear household budget constraint with transfers and taxes:

• C1 + C2/(1+r1) + · · · = (1+r0)·( B0/P+K0)

+(w/P)1·Ls1 +(w/P)2 · Ls

2 /(1+r1) + ·· ·

+( V1 − T1) + ( V2 − T2)/( 1 + r1)

+( V3 − T3)/[(1+ r1) · ( 1 + r2) ] + ·· ·


Permanent Changes in Government Purchases

• TheoryG + V = T

or

V − T = −G– If G rises by one unit each year, V − T falls by one

unit each year. – Household’s disposable real income falls by one unit

each year.



• Theory– Since the typical household has one less unit of real

disposable income each year, we predict that the decrease in C each year will be roughly by one unit.



• Theory– How the increase in government purchases affects

the demand and supply of capital services and real GDP.

• An increase in government purchases, G, does not shift the curves for the demand or supply of capital services.

– The market-clearing real rental price, (R/P)∗, and quantity of capital services, (κK)∗, do not change.



• Theory– We found that the quantity of capital services, κK, is

unchanged, and we assumed that the technology level, A, and the quantity of labour input, L, are fixed.

– Therefore, Y is unchanged. – The important conclusion is that a permanent

increase in government purchases does not affect real GDP.



• Theoryr = ( R/ P) · κ − δ(κ)

• A permanent increase in government purchases does not affect the real interest rate.



• TheoryG, does not shift labour supply, Ls, which is fixed at L, and does not shift the labour demand curve, Ld.

• The market-clearing real wage rate, (w/P)∗, does not change.

• We conclude that a permanent increase in government purchases does not affect the real wage rate.



• Theory– We know from our analysis of income effects that a

permanent rise in government purchases, G, by one unit reduces C in each year by roughly one unit.



• Theory– The intertemporal-substitution effect depends on the

real interest rate, r. Since r does not change, the intertemporal-substitution effect does not operate. Another substitution effect involves consumption and leisure, but we have assumed that the quantity of labour and, hence, the quantity of leisure, is fixed. In any event, this substitution effect depends on the real wage rate, w/P, which does not change.



• Theory– Our prediction is that a permanent increase in

government purchases by one unit causes consumption to decrease by about one unit.



• Theory

Y = C+ I + G• The changes in C and G fully offset each other

and, thereby, allow investment, I, to remain unchanged.



• Theory– We predict that a permanent increase in government

purchases, G, • Reduces consumption, C, roughly one to one.• The variables that do not change include real

GDP, Y; gross investment, I; the quantity of capital services, κK; the real rental price, R/P; the real interest rate, r; and the real wage rate, w/P.


Temporary Changes in Government Purchases

• Theory– Assume now that year 1’s real government

purchases, G1, rise by one unit, while those for other years, Gt, do not change. That is, everyone expects that Gt in future years will return to the original level.



• TheoryVt− Tt= −Gt

Vt− Tt falls by one unit, and households have one unit less of real disposable income. In subsequent years, Vt − Tt and, hence, real disposable income return to their original levels.



• Theory– Households would spread their reduced disposable

income in year 1 over reduced consumption, Ct, in all years t. Therefore, the effect on year 1’s consumption, C1, will be relatively small. The propensity to consume out of a temporary change in income is greater than zero, but much less than one.



• TheoryY = C+ I + G

Y, is unchanged; real government purchases, G, are higher in year 1 by one unit; and consumption, C, is lower, but by much less than one unit. Consequently, equation (12.9) implies that gross investment, I, must fall.



• Theory– Since the decrease in C is relatively small, the decline

in I is large. That is, year 1’s extra G comes mainly at the expense of I, rather than C.

– When the change in G was permanent, we predicted that most or all of the extra G came at the expense of C.


Government Purchases and Real GDP During Wartime: Empirical

• We test the model by studying the response of the economy to the temporary changes in government purchases that have accompanied U.S. wars.



• The data also show that the rises in real GDP are by less than the increases in government purchases. That is, aside from military purchases, the totals of the other components of real GDP are down during wartime. The model accords with this pattern. However, the components of real GDP other than military purchases do not fall nearly as much as predicted by the model.


Wartime Effects on the Economy

• Employment during wartime– The basic pattern is that the military took in a

significant number of persons total employment expanded a little more.



• Effects of war on labour supply– At this point, there is no settled view among economists about the

best way to understand labour supply during wartime.

• A large expansion of real government purchases, G, means that households have less real disposable income.

• Casey Mulligan (1998) argues that labour supply, Ls, increases during wartime because of patriotism.

• The military draft would affect the labour supply of single women.



• Employment Effects on Labour Markets

– Prediction that a war reduces the real wage rate, w/P.



• Effects of war on the rental market– A wartime increase in labour supply, Ls, led to an

increase in labour input, L. This change affects the rental market, because the rise in L tends to increase the MPK (for a given quantity of capital services, κK).

• The demand curve shifts right because the higher quantity of labour, L, raises the MPK for a given quantity of capital



• Effects of war on the rental market– For a given capital stock, K, the rise in κK

corresponds to an increase in the capital utilization rate, κ.

r = ( R/ P) · κ − δ(κ)• Increases in R/P and κ imply that r increases.



• Effects of war on the rental market– The predictions for higher real interest rates during

wartime conflict with the U.S. data.

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