Introduction

In all other chapters of this book, the government's budget deficit is exogenous. The lump-sum tax, Th, is adjusted continuously to maintain a balanced budget or the deficit selected for policy purposes. Under this specification, the supply of domestic bonds is likewise exogenous. This description of fiscal policy is excessively simple and not the one most frequently employed. It is more common to assume that the government selects a level of expenditure in nominal or real terms together with an income tax (plus, possibly, a lump-sum tax). The budget deficit is made to be endogenous, because income-tax collections are endogenous, and so is the supply of government bonds. For purposes of short-run analysis, at least, this income-tax specification represents reality more closely than the specification adopted in this book.

In this chapter we introduce an income tax into the standard version of our model in order to compare patterns of behavior when the budget deficit is endogenous with those when it is exogenous. We study the responses to fiscal policies–a balanced-budget increase in government expenditure and a tax reduction–and the responses to an open-market purchase. We show that short-run outcomes do not differ markedly under alternative tax specifications but that long-run outcomes differ fundamentally. The differences in long-run outcomes lead us to suggest that the exogenous-deficit specification is preferable for certain purposes to the more familiar endogenous-deficit specification.