Principles of Macroeconomics, Case/Fair/Oster, 11e

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PRINCIPLES OF MACROECONOMICS E L E V E N T H E D
I T I O N
CASE ? FAIR ? OSTER
PEARSON
Prepared by Fernando Quijano w/Shelly Tefft
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(No Transcript)
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9
The Government and Fiscal Policy
CHAPTER OUTLINE
Government in the Economy Government Purchases
(G), Net Taxes (T), and Disposable Income
(Yd) The Determination of Equilibrium Output
(Income) Fiscal Policy at Work Multiplier
Effects The Government Spending Multiplier The
Tax Multiplier The Balanced-Budget
Multiplier The Federal Budget The Budget in
2012 Fiscal Policy Since 1993 The Clinton,
Bush, and Obama Administrations The
Federal Government Debt The Economys Influence
on the Government Budget Automatic Stabilizers
and Destabilizers Full-Employment
Budget Looking Ahead Appendix A Deriving the
Fiscal Policy Multipliers Appendix B The Case
in Which Tax Revenues Depend on Income
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fiscal policy The governments spending and
taxing policies.
monetary policy The behavior of the Federal
Reserve concerning the nations money supply.
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The behavior of the Federal Reserve concerning
the nations money supply is called a. Discretion
ary fiscal policy. b. Automatic fiscal
policy. c. Budgetary policy. d. Monetary policy.
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The behavior of the Federal Reserve concerning
the nations money supply is called a. Discretion
ary fiscal policy. b. Automatic fiscal
policy. c. Budgetary policy. d. Monetary policy.
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Government in the Economy
discretionary fiscal policy Changes in taxes or
spending that are the result of deliberate
changes in government policy.
Government Purchases (G), Net Taxes (T), and
Disposable Income (Yd)
net taxes (T) Taxes paid by firms and households
to the government minus transfer payments made to
households by the government.
disposable, or after-tax, income (Yd) Total
income minus net taxes Y - T.
disposable income total income - net taxes Yd
Y - T
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Over which of the following categories does the
government have more control? a. Tax
revenue. b. Government expenditures. c. Tax
rates. d. The size of corporate profits.
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Over which of the following categories does the
government have more control? a. Tax
revenue. b. Government expenditures. c. Tax
rates. d. The size of corporate profits.
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? FIGURE 9.1 Adding Net Taxes (T) and
Government Purchases (G) to the Circular Flow of
Income
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The disposable income (Yd) of households must end
up as either consumption (C) or saving (S). Thus,
Because disposable income is aggregate income (Y)
minus net taxes (T), we can write another
identity
By adding T to both sides
Planned aggregate expenditure (AE) is the sum of
consumption spending by households (C), planned
investment by business firms (I), and government
purchases of goods and services (G).
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Select the best answer. Households use their
disposable income (Yd) to do the
following a. Consume. b. Consume and
save. c. Consume, save, and pay
taxes. d. Consume, save, pay taxes, and buy
imports.
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Select the best answer. Households use their
disposable income (Yd) to do the
following a. Consume. b. Consume and
save. c. Consume, save, and pay
taxes. d. Consume, save, pay taxes, and buy
imports.
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budget deficit The difference between what a
government spends and what it collects in taxes
in a given period G - T.
budget deficit G - T
Adding Taxes to the Consumption Function
To modify our aggregate consumption function to
incorporate disposable income instead of
before-tax income, instead of C a bY, we write
C a bYd or C a b(Y - T)
Our consumption function now has consumption
depending on disposable income instead of
before-tax income.
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When government enters the circular flow of
income, which of the following is an expression
for planned aggregate expenditure? a. Y - T b. C
S T c. C I G d. G - T
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When government enters the circular flow of
income, which of the following is an expression
for planned aggregate expenditure? a. Y - T b. C
S T c. C I G d. G - T
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Planned Investment
The government can affect investment behavior
through its tax treatment of depreciation and
other tax policies. Planned investment depends
on the interest rate, both of which we continue
to assume are fixed for purposes of this chapter.
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The Determination of Equilibrium Output (Income)
Y C I G
TABLE 9.1 Finding Equilibrium for I 100, G 100, and T 100 TABLE 9.1 Finding Equilibrium for I 100, G 100, and T 100 TABLE 9.1 Finding Equilibrium for I 100, G 100, and T 100 TABLE 9.1 Finding Equilibrium for I 100, G 100, and T 100 TABLE 9.1 Finding Equilibrium for I 100, G 100, and T 100 TABLE 9.1 Finding Equilibrium for I 100, G 100, and T 100 TABLE 9.1 Finding Equilibrium for I 100, G 100, and T 100 TABLE 9.1 Finding Equilibrium for I 100, G 100, and T 100 TABLE 9.1 Finding Equilibrium for I 100, G 100, and T 100 TABLE 9.1 Finding Equilibrium for I 100, G 100, and T 100 TABLE 9.1 Finding Equilibrium for I 100, G 100, and T 100
(1) (2) (3) (4) (5) (6) (7) (8) (9) (9) (10)
Output(Income)Y NetTaxesT DisposableIncomeYd Y -T ConsumptionSpendingC 100 .75 Yd SavingSYd C PlannedInvestmentSpendingI GovernmentPurchasesG PlannedAggregateExpenditure C I G UnplannedInventoryChangeY - (C I G) UnplannedInventoryChangeY - (C I G) Adjustmentto Disequi-librium

300 100 200 250 - 50 100 100 450 - 150 Output ? Output ?
500 100 400 400 0 100 100 600 - 100 Output ? Output ?
700 100 600 550 50 100 100 750 - 50 Output ? Output ?
900 100 800 700 100 100 100 900 0 Equilibrium Equilibrium
1,100 100 1,000 850 150 100 100 1,050 50 Output ? Output ?
1,300 100 1,200 1,000 200 100 100 1,200 100 Output ? Output ?
1,500 100 1,400 1,150 250 100 100 1,350 150 Output ? Output ?

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? FIGURE 9.2 Finding Equilibrium Output/Income
Graphically
Because G and I are both fixed at 100, the
aggregate expenditure function is the new
consumption function displaced upward by I G
200. Equilibrium occurs at Y C I G 900.
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The Saving/Investment Approach to Equilibrium
saving/investment approach to equilibrium S
T I G
To derive this, we know that in equilibrium,
aggregate output (income) (Y) equals planned
aggregate expenditure (AE). By definition, AE
equals C I G, and by definition, Y equals C
S T. Therefore, at equilibrium C S T C
I G Subtracting C from both sides leaves S
T I G
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In the circular flow that includes households,
firms, and government, which of the following
expressions is the leakages/injections approach
to equilibrium? a. Y C I G. b. C S I
G. c. Y a bT I G. d. S T I G.
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In the circular flow that includes households,
firms, and government, which of the following
expressions is the leakages/injections approach
to equilibrium? a. Y C I G. b. C S I
G. c. Y a bT I G. d. S T I G.
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Fiscal Policy at Work Multiplier Effects

• At this point, we are assuming that the
  government controls G and T. In this section, we
  will review three multipliers
• Government spending multiplier
• Tax multiplier
• Balanced-budget multiplier

The Government Spending Multiplier
government spending multiplier The ratio of the
change in the equilibrium level of output to a
change in government spending.
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TABLE 9.2 Finding Equilibrium after a Government Spending Increase of 50 (G Has Increased from 100 in Table 9.1 to 150 Here) TABLE 9.2 Finding Equilibrium after a Government Spending Increase of 50 (G Has Increased from 100 in Table 9.1 to 150 Here) TABLE 9.2 Finding Equilibrium after a Government Spending Increase of 50 (G Has Increased from 100 in Table 9.1 to 150 Here) TABLE 9.2 Finding Equilibrium after a Government Spending Increase of 50 (G Has Increased from 100 in Table 9.1 to 150 Here) TABLE 9.2 Finding Equilibrium after a Government Spending Increase of 50 (G Has Increased from 100 in Table 9.1 to 150 Here) TABLE 9.2 Finding Equilibrium after a Government Spending Increase of 50 (G Has Increased from 100 in Table 9.1 to 150 Here) TABLE 9.2 Finding Equilibrium after a Government Spending Increase of 50 (G Has Increased from 100 in Table 9.1 to 150 Here) TABLE 9.2 Finding Equilibrium after a Government Spending Increase of 50 (G Has Increased from 100 in Table 9.1 to 150 Here) TABLE 9.2 Finding Equilibrium after a Government Spending Increase of 50 (G Has Increased from 100 in Table 9.1 to 150 Here) TABLE 9.2 Finding Equilibrium after a Government Spending Increase of 50 (G Has Increased from 100 in Table 9.1 to 150 Here)
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
Output(Income)Y NetTaxesT DisposableIncomeYd Y -T ConsumptionSpendingC 100 .75 Yd SavingSYd C PlannedInvestmentSpendingI GovernmentPurchasesG PlannedAggregateExpenditure C I G UnplannedInventoryChangeY - (C I G) AdjustmenttoDisequilibrium
300 100 200 250 - 50 100 150 500 - 200 Output ?
500 100 400 400 0 100 150 650 - 150 Output ?
700 100 600 550 50 100 150 800 - 100 Output ?
900 100 800 700 100 100 150 950 - 50 Output ?
1,100 100 1,000 850 150 100 150 1,100 0 Equilibrium
1,300 100 1,200 1,000 200 100 150 1,250 50 Output ?
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How much of an increase in government spending
would be required to generate a 200 billion
increase in the equilibrium level of
output? a. An amount less than 200 billion in
government spending. b. An amount greater than
200 billion in government spending. c. Exactly
200 billion in government spending. d. None of
the above. Equilibrium output does not change
with changes in government spending.
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How much of an increase in government spending
would be required to generate a 200 billion
increase in the equilibrium level of
output? a. An amount less than 200 billion in
government spending. b. An amount greater than
200 billion in government spending. c. Exactly
200 billion in government spending. d. None of
the above. Equilibrium output does not change
with changes in government spending.
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? FIGURE 9.3 The Government Spending Multiplier
Increasing government spending by 50 shifts the
AE function up by 50. As Y rises in response,
additional consumption is generated. Overall,
the equilibrium level of Y increases by 200, from
900 to 1,100.
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The Tax Multiplier
tax multiplier The ratio of change in the
equilibrium level of output to a change in taxes.
Because the initial change in aggregate
expenditure caused by a tax change of ?T is (-?T
MPC), we can solve for the tax multiplier by
substitution
Because a tax cut will cause an increase in
consumption expenditures and output and a tax
increase will cause a reduction in consumption
expenditures and output, the tax multiplier is a
negative multiplier
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The Balanced-Budget Multiplier
balanced-budget multiplier The ratio of change
in the equilibrium level of output to a change in
government spending where the change in
government spending is balanced by a change in
taxes so as not to create any deficit. The
balanced-budget multiplier is equal to 1 The
change in Y resulting from the change in G and
the equal change in T are exactly the same size
as the initial change in G or T.
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TABLE 9.3 Finding Equilibrium after a Balanced-Budget Increase in G and T of 200 Each (Both G and T Have Increased from 100 in Table 9.1 to 300 Here) TABLE 9.3 Finding Equilibrium after a Balanced-Budget Increase in G and T of 200 Each (Both G and T Have Increased from 100 in Table 9.1 to 300 Here) TABLE 9.3 Finding Equilibrium after a Balanced-Budget Increase in G and T of 200 Each (Both G and T Have Increased from 100 in Table 9.1 to 300 Here) TABLE 9.3 Finding Equilibrium after a Balanced-Budget Increase in G and T of 200 Each (Both G and T Have Increased from 100 in Table 9.1 to 300 Here) TABLE 9.3 Finding Equilibrium after a Balanced-Budget Increase in G and T of 200 Each (Both G and T Have Increased from 100 in Table 9.1 to 300 Here) TABLE 9.3 Finding Equilibrium after a Balanced-Budget Increase in G and T of 200 Each (Both G and T Have Increased from 100 in Table 9.1 to 300 Here) TABLE 9.3 Finding Equilibrium after a Balanced-Budget Increase in G and T of 200 Each (Both G and T Have Increased from 100 in Table 9.1 to 300 Here) TABLE 9.3 Finding Equilibrium after a Balanced-Budget Increase in G and T of 200 Each (Both G and T Have Increased from 100 in Table 9.1 to 300 Here) TABLE 9.3 Finding Equilibrium after a Balanced-Budget Increase in G and T of 200 Each (Both G and T Have Increased from 100 in Table 9.1 to 300 Here)
(1) (2) (3) (4) (5) (6) (7) (8) (9)
Output(Income)Y NetTaxesT DisposableIncomeYd Y - T ConsumptionSpendingC 100 .75 Yd PlannedInvestmentSpendingI GovernmentPurchasesG PlannedAggregateExpenditure C I G UnplannedInventoryChangeY - (C I G) AdjustmenttoDisequilibrium
500 300 200 250 100 300 650 -150 Output ?
700 300 400 400 100 300 800 -100 Output ?
900 300 600 550 100 300 950 -50 Output ?
1,100 300 800 700 100 300 1,100 0 Equilibrium
1,300 300 1,000 850 100 300 1,250 50 Output ?
1,500 300 1,200 1,000 100 300 1,400 100 Output ?
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• What happens when there is a simultaneous
  increase in government spending of 100 and a
  lump-sum tax of 100?
• a. Equilibrium income would increase by 100, or
  the amount of increase in G.
• b. Equilibrium income would decrease by 100, or
  the amount of increase in T.
• Equilibrium income would decrease by 200, or
  double the amount of the increase in T.
• Nothing happens. Equilibrium income remains the
  same because the amount of government spending
  (G) is compensated by the amount of taxation (T).

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• What happens when there is a simultaneous
  increase in government spending of 100 and a
  lump-sum tax of 100?
• a. Equilibrium income would increase by 100, or
  the amount of increase in G.
• b. Equilibrium income would decrease by 100, or
  the amount of increase in T.
• Equilibrium income would decrease by 200, or
  double the amount of the increase in T.
• Nothing happens. Equilibrium income remains the
  same because the amount of government spending
  (G) is compensated by the amount of taxation (T).

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TABLE 9.4 Summary of Fiscal Policy Multipliers TABLE 9.4 Summary of Fiscal Policy Multipliers TABLE 9.4 Summary of Fiscal Policy Multipliers TABLE 9.4 Summary of Fiscal Policy Multipliers
Policy Stimulus Multiplier Final Impact onEquilibrium Y
Government spendingmultiplier Increase or decrease in thelevel of governmentpurchases ?G

Tax multiplier Increase or decrease in thelevel of net taxes ?T

Balanced-budgetmultiplier Simultaneous balanced-budgetincrease or decrease in thelevel of government purchases and net taxes ?G ?T 1
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A Warning
Although we have added government, the story told
about the multiplier is still incomplete and
oversimplified. We have been treating net taxes
(T) as a lump-sum, fixed amount, whereas in
practice, taxes depend on income. Appendix B to
this chapter shows that the size of the
multiplier is reduced when we make the more
realistic assumption that taxes depend on
income. We continue to add more realism and
difficulty to our analysis in the chapters that
follow.
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The Federal Budget
Because fiscal policy is the manipulation of
items in the federal budget, that budget is
relevant to our study of macroeconomics.
federal budget The budget of the federal
government.
An enormously complicated document up to
thousands of pages each year, the federal budget
lists in detail all the things the government
plans to spend money on and all the sources of
government revenues for the coming year. It is
the product of a complex interplay of social,
political, and economic forces.
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The federal budget incorporates a. Plans for
government spending. b. Sources of government
revenue. c. Social, political, and economic
forces. d. All of the above.
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The federal budget incorporates a. Plans for
government spending. b. Sources of government
revenue. c. Social, political, and economic
forces. d. All of the above.
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The Budget in 2012
TABLE 9.5 Federal Government Receipts and Expenditures, 2012 (Billions of Dollars) TABLE 9.5 Federal Government Receipts and Expenditures, 2012 (Billions of Dollars) TABLE 9.5 Federal Government Receipts and Expenditures, 2012 (Billions of Dollars) TABLE 9.5 Federal Government Receipts and Expenditures, 2012 (Billions of Dollars) TABLE 9.5 Federal Government Receipts and Expenditures, 2012 (Billions of Dollars)
Amount Percentage of Total
Current receipts Current receipts Current receipts
Personal income taxes Personal income taxes 1,137.8 42.5
Excise taxes and customs duties Excise taxes and customs duties 116.1 4.3
Corporate income taxes Corporate income taxes 373.7 14.0
Taxes from the rest of the world Taxes from the rest of the world 17.3 0.6
Contributions for social insurance Contributions for social insurance 934.8 35.0
Interest receipts and rents and royalties Interest receipts and rents and royalties 53.4 2.0
Current transfer receipts from business and persons Current transfer receipts from business and persons 59.2 2.2
Current surplus of government enterprises Current surplus of government enterprises - 17.8 - 0.7
Total 2,674.5 100.0
Current expenditures Current expenditures Current expenditures
Consumption expenditures Consumption expenditures 1,059.6 28.2
Transfer payments to persons Transfer payments to persons 1,773.2 47.2
Transfer payments to the rest of the world Transfer payments to the rest of the world 76.4 2.0
Grants-in-aid to state and local governments Grants-in-aid to state and local governments 468.0 12.5
Interest payments Interest payments 318.5 8.5
Subsidies Subsidies 60.4 1.6
Total 3,756.1 100.0
Net federal government savingsurplus () or deficit (-) (Total current receipts - Total current expenditures) Net federal government savingsurplus () or deficit (-) (Total current receipts - Total current expenditures) Net federal government savingsurplus () or deficit (-) (Total current receipts - Total current expenditures) - 1,081.6
federal surplus () or deficit (-) Federal
government receipts minus expenditures.
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Fiscal Policy Since 1993 The Clinton, Bush, and
Obama Administrations
? FIGURE 9.4 Federal Personal Income Taxes as a
Percentage of Taxable Income, 1993 I2012 IV
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? FIGURE 9.5 Federal Government Consumption
Expenditures as a Percentage of GDP and Federal
Transfer Payments and Grants-in-Aid as a
Percentage of GDP, 1993 I2012 IV
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? FIGURE 9.6 The Federal Government Surplus ()
or Deficit (-) as a Percentage of GDP, 1993
I2012 IV
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After a large deficit buildup in the 1980s, the
federal government deficit a. Continued to
worsen steadily throughout the 1990s and into the
2000s. b. Turned into a surplus during the two
Clinton administrations. c. Was vastly diminished
during the G.W. Bush administrations. d. Was
virtually eliminated by the Obama administration.
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After a large deficit buildup in the 1980s, the
federal government deficit a. Continued to
worsen steadily throughout the 1990s and into the
2000s. b. Turned into a surplus during the two
Clinton administrations. c. Was vastly diminished
during the G.W. Bush administrations. d. Was
virtually eliminated by the Obama administration.
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E C O N O M I C S I N P R A C T I C E
The U.S. Congress Fights about the Budget
In January 2013, Congress signed the American Tax
Relief Act (ATRA), which retained many of the
earlier Bush tax cuts, while modifying others.
But the specter of automatic spending cuts
remained. In the spring of 2013, arguments about
the shape of the 2014 budget were raging, as
members of the House commented on a budget
proposal of Paul Ryan, Republican Congressman
from Wisconsin. Representative Eddie Bernice
Johnson of Texas, a Democrat, had this to say
about Congressman Ryans bill This budget would
not only jeopardize seniors, families and the
most vulnerable in our society, it would also
destroy jobs and put our nations economic
recovery at risk. The Congress heard a
different view from Andy Barr, a new Republican
Congressman from Kentucky Families and small
businesses should be able to keep more of their
hard-earned income instead of having it wasted by
Washington bureaucrats.

• THINKING PRACTICALLY
• How would you describe the views of the two
  people quoted on the benefits of government
  spending?

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The Federal Government Debt
federal debt The total amount owed by the
federal government.
privately held federal debt The privately held
(non-government-owned) debt of the U.S.
government.
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? FIGURE 9.7 The Federal Government Debt as a
Percentage of GDP, 1993 I2012 IV
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E C O N O M I C S I N P R A C T I C E
The Debt Clock
Next time you are in New York City, wander by
West 44th Street and the Avenue of the
Americas. Located on an outside wall is a U.S.
Debt Clock, mounted by Seymour Durst, a N.Y. real
estate developer. Rather than showing us the
passage of time, as would a conventional clock,
this clock shows us the mounting of the U.S.
debt. Durst was an early worrier about the debt!
Needless to say, it sped up during the Obama
administration. See Figure 9.7.

• THINKING PRACTICALLY
• For a few years beginning in 2000, the clock was
  stopped and covered up.
• Can you guess why based on the data you have
  seen in this chapter?

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The Economys Influence on the Government Budget
Automatic Stabilizers and Destabilizers
automatic stabilizers Revenue and expenditure
items in the federal budget that automatically
change with the state of the economy in such a
way as to stabilize GDP.
automatic destabilizer Revenue and expenditure
items in the federal budget that automatically
change with the state of the economy in such a
way as to destabilize GDP.
fiscal drag The negative effect on the economy
that occurs when average tax rates increase
because taxpayers have moved into higher income
brackets during an expansion.
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Which of the following statements is correct
about the governments control over its
budget? a. The government has complete control
over the revenue side of the budget, but not
complete control over the expenditure
side. b. The government has complete control over
the expenditure side of the budget, but not
complete control over the revenue side. c. The
government does not have complete control of
either the revenue side or the expenditure side
of the budget. d. The size of the government
budget, and whether it is in surplus or deficit,
is controlled entirely by Congress, not by the
economy.
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Which of the following statements is correct
about the governments control over its
budget? a. The government has complete control
over the revenue side of the budget, but not
complete control over the expenditure
side. b. The government has complete control over
the expenditure side of the budget, but not
complete control over the revenue side. c. The
government does not have complete control of
either the revenue side or the expenditure side
of the budget. d. The size of the government
budget, and whether it is in surplus or deficit,
is controlled entirely by Congress, not by the
economy.
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Full-Employment Budget
full-employment budget What the federal budget
would be if the economy were producing at the
full-employment level of output.
structural deficit The deficit that remains at
full employment.
cyclical deficit The deficit that occurs because
of a downturn in the business cycle.
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When the economy reaches full employment, the
budget deficit is a. A combination of cyclical
and structural deficits. b. Zero. c. Equal to the
cyclical deficit. d. Equal to the structural
deficit.
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When the economy reaches full employment, the
budget deficit is a. A combination of cyclical
and structural deficits. b. Zero. c. Equal to the
cyclical deficit. d. Equal to the structural
deficit.
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Looking Ahead
We have now seen how households, firms, and the
government interact in the goods market, how
equilibrium output (income) is determined, and
how the government uses fiscal policy to
influence the economy. In the following two
chapters, we analyze the money market and
monetary policythe governments other major tool
for influencing the economy.
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R E V I E W T E R M S A N D C O N C E P T S
automatic destabilizers automatic
stabilizers balanced-budget multiplier budget
deficit cyclical deficit discretionary fiscal
policy disposable, or after-tax, income
(Yd) federal budget federal debt federal surplus
() or deficit (-) fiscal drag fiscal
policy full-employment budget government spending
multiplier monetary policy net taxes (T)
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CHAPTER 9 APPENDIX A
Deriving the Fiscal Policy Multipliers
The Government Spending and Tax Multipliers
We can derive the multiplier algebraically using
our hypothetical consumption function
The equilibrium condition is
By substituting for C, we get
This equation can be rearranged to yield
Now solve for Y by dividing through by (1 - b)
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The Balanced-Budget Multiplier

• It is easy to show formally that the
  balanced-budget multiplier 1.

In a balanced-budget increase, ?G ?T so in the
above equation for the net initial increase in
spending we can substitute ?G for ?T.
?G - ?G (MPC) ?G (1 - MPC)
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Because MPS (1 - MPC), the net initial increase
in spending is
?G (MPS)
Thus, the final total increase in the equilibrium
level of Y is just equal to the initial balanced
increase in G and T.
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CHAPTER 9 APPENDIX B
The Case in Which Tax Revenues Depend on Income
? FIGURE 9B.1 The Tax Function
This graph shows net taxes (taxes minus transfer
payments) as a function of aggregate income.
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? FIGURE 9B.2 Different Tax Systems
When taxes are strictly lump-sum (T 100) and do
not depend on income, the aggregate expenditure
function is steeper than when taxes depend on
income.
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The Government Spending and Tax Multipliers
Algebraically
We know that Y C I G. Through substitution
we get
Solving for Y
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This means that a 1 increase in G or I (holding
a and T0 constant) will increase the equilibrium
level of Y by
Holding a, I, and G constant, a fixed or lump-sum
tax cut (a cut in T0) will increase the
equilibrium level of income by