What is 'Pump Priming'

 Pump priming is the action taken to stimulate an economy, usually during a

recessionary period, through government spending, and interest rate and tax
reductions. The term pump priming is derived from the operation of older
pumps; a suction valve had to be primed with water so that the pump would
function properly.

 Injection of (relatively small) sums of money by a government into a depressed

economy through commissioning of public works.

 Its objective is to increase purchasing power of people that will stimulate

demand which in turn will boost private sector investment, and so more and
more money will be pumped into the economy.

BREAKING DOWN 'Pump Priming'

Pump priming assumes that the economy must be primed to function properly once
again. In this regard, government spending is assumed to stimulate private
spending, which in turn should lead to economic expansion.

Small Amounts of Government Funds

Pump priming involves introducing relatively small amounts of government funds

into a depressed economy in order to spur growth. This is accomplished through
the increase in purchasing power experienced by those affected by the injection
of funds, with the goal of prompting higher demand for goods and services. The
increase in demand experienced through pump priming can lead to increased
profitability within the private sector, which assists with overall economic
recovery.

Pump priming relates to the Keynesian economic theory, named after noted
economist John Maynard Keynes, which states that government intervention within
the economy, aimed at increasing aggregate demand, can result in a positive shift
within the economy. This is based on the cyclic nature of money within an economy,
in which one person’s spending directly relates to another person’s earnings, and
that increase in earnings leads to a subsequent increase in spending.
The action of government relating to its expenditures, transfers and taxes is
called the fiscal policy. Here we focus on three fiscal policy models which are in
increasing order of complexity, with the emphasis being on the government
expenditure, taxation and the income level.

Determination of Equilibrium Income or Output In a Three Sector Economy

Though the government is involved in a variety of activates three of them are of

greater relevance to us in the present context. Hence we will focus on these
activities of the government, which are discussed below:

1. Government Expenditure

This includes goods purchased by the central, state and the local government
and also the payments made to the government employees.

2. Transfers

These are those government payments which do not involve any direct
services by the recipient for instance welfare payments, unemployment
insurance and others.

3. Taxes

These include taxes on property, income and goods. Taxes can be classified
into two categories, direct taxes and indirect taxes. Direct taxes are levied
directly and include personal income and corporate income tax. They are paid
as a part of the price of the goods.

We simplify our analysis by making a few postulations, which are as follows.

1. The government purchases factor services from the household sector and
goods and services from the firms.

2. Transfer payment includes subsidies to the firms and pensions to the

household sector.
 3. The government levels only direct taxes on the household sector. We here
introduce the notion of an income leakage and an injection. In a two sector
model, a part of the current income stream leaked out as saving whereas
injections in the form of investment were injected into the system.

In a three sector model taxes, like saving, are income leakages whereas
government expenditures like investment are injections.

Let us see few illustrations relating to a three sector economy.

Illustration 21

In a two sector economy, the basic equations are as follows:

The Consumption function is C = 200 + 0.8Yd and investment is I = 300 millions. The
equilibrium level of income is 2500 millions. Presume the government is added to
this two sector model, which then becomes a three sector economy. The
government expenditure is at 100 millions

1. Determine the equilibrium level of income in the three sector economy

2. What is the multiplier affect of the government expenditure? Is it of the
same magnitude as the multiplier effect of a change in the autonomous
investment?
3. Presume that there is a balanced budget in that the entire government
expenditure is financed from a lump sum tax. Find the new equilibrium level
of income in the three sector economy.

Solution

The equilibrium condition in the three sector economy is given as

Y = C+I+G
Thus,
Y = 200 + 0.8Y + 300 + 100

Y = 600 + 0.8Y

Y – 0.8Y = 600

0.2Y = 600
 Y = 600 / 0.2

The equilibrium level of income in the three sector economy is 3,000 millions,
which is an increase by 500 millions over the two sector economy.

Government Expenditure Multiplier

GM = ΔY = 1
ΔG 1–b

= 1 / 1 – 0.80

= 5

Investment Multiplier, m = ΔY = 1
ΔI 1–b

Where b is the marginal propensity to consume,

Thus the magnitude of the multiplier effect is the same as that of a change in
government expenditure.

G = T = 100 millions
Thus,
C = 200 + 0.8 (Y -100)

C = 200 – 80 + 0.8Y

C = 120 + 0.8Y

But, Y = C+I+G

Y = 120 + 0.8Y + 300 + 100

Y – 0.8Y = 120 + 400

0.2Y = 520

Y = 520 / 0.2
The new equilibrium level of income in the three sector economy, when there
exists a balanced budget is 2,600 millions.

Illustration 22

In an economy, the full employment output occurs at 2000 millions. The marginal
propensity to consume is 0.8 and the equilibrium level of output is currently at
1600 millions. Suppose the government aspires to achieve the full employment
output, find the change in

1. The level of government expenditures

2. Net lump sum tax
3. The level of government expenditures and the net lump sum tax when the
government aims at bringing the productivity the full employment while
keeping the budget balanced

Solution

We have, GM =

ΔY = 1
ΔG 1-b

Where, Δ G = Change in government expenditure

b = Marginal propensity to consume

ΔY = Change in income

GM = Government expenditure multiplier

For instance,

b = 0.80

ΔY = 2000 – 1600

ΔY = 400

Thus,
400 / Δ G = 1 / 1- 0.8
 ΔG = 400 (0.2)

Thus, the level of government expenditures required to achieve the full

employment output is 80 millions

We have, GF =

ΔY = -b
ΔT 1–b
Where,
ΔT = Change in tax

b = marginal propensity to
consume

ΔY = Change in income

GF = Government tax multiplier

As the tax multiplier is negative, an increase in tax leads to a decrease in the

equilibrium level of income.

For instance,
b = 0.80

ΔY = 2000 – 1600 = 400

Thus,
400 = - 0.80
ΔT 1 – 0.80

-0.8 Δ T = 400 (0.20)

The net lump sum tax is – 100 millions. There should be a decrease in lump
sum tax by 100 millions

The next equation to solve is

ΔY = 1 (-b Δ T + Δ Ḡ)
1–b
But, ΔG = ΔT
Thus we can write
ΔY = 1 (-b Δ Ḡ + Δ Ḡ)
1–b
Or
Δ Y (1-b) = Δ Ḡ (-b +1)

Or Δ Y (1-b) = Δ Ḡ (1-b)

Or
ΔY = 1–b = 1
ΔG = 1–b

ΔY = ΔG = 400