Principles of Macroeconomics, Case/Fair/Oster, 10e

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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
2009 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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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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Government in the Economy
Government Purchases (G), Net Taxes (T), and
Disposable Income (Yd)
? FIGURE 9.1 Adding Net Taxes (T) and
Government Purchases (G) to the Circular Flow of
Income
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Government in the Economy
Government Purchases (G), Net Taxes (T), and
Disposable Income (Yd)
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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Government in the Economy
Government Purchases (G), Net Taxes (T), and
Disposable Income (Yd)
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
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Government in the Economy
Government Purchases (G), Net Taxes (T), and
Disposable Income (Yd)
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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Government in the Economy
Government Purchases (G), Net Taxes (T), and
Disposable Income (Yd)
Planned Investment
The government can affect investment behavior
through its tax treatment of depreciation and
other tax policies.
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Government in the Economy
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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Government in the Economy
The Determination of Equilibrium Output (Income)
? 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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Government in the Economy
The Determination of Equilibrium Output (Income)
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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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

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Fiscal Policy at Work Multiplier Effects
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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Fiscal Policy at Work Multiplier Effects
The Government Spending Multiplier
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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Fiscal Policy at Work Multiplier Effects
The Government Spending Multiplier
? 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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Fiscal Policy at Work Multiplier Effects
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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Fiscal Policy at Work Multiplier Effects
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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Fiscal Policy at Work Multiplier Effects
The Balanced-Budget Multiplier
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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Fiscal Policy at Work Multiplier Effects
The Balanced-Budget Multiplier
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 purchasesand net taxes ?G ?T 1
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Fiscal Policy at Work Multiplier Effects
The Balanced-Budget Multiplier
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
federal budget The budget of the federal
government.
The budget is really three different
budgets It is a political document that
dispenses favors to certain groups or regions and
places burdens on others. It is a reflection of
goals the government wants to achieve. The
budget may be an embodiment of some beliefs about
how (if at all) the government should manage the
macroeconomy.
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The Federal Budget
The Budget in 2009
TABLE 9.5 Federal Government Receipts and Expenditures, 2009 (Billions of Dollars) TABLE 9.5 Federal Government Receipts and Expenditures, 2009 (Billions of Dollars) TABLE 9.5 Federal Government Receipts and Expenditures, 2009 (Billions of Dollars) TABLE 9.5 Federal Government Receipts and Expenditures, 2009 (Billions of Dollars) TABLE 9.5 Federal Government Receipts and Expenditures, 2009 (Billions of Dollars)
Amount Percentage of Total
Current receipts Current receipts Current receipts
Personal income taxes Personal income taxes 828.7 37.2
Excise taxes and customs duties Excise taxes and customs duties 92.3 4.1
Corporate income taxes Corporate income taxes 231.0 10.4
Taxes from the rest of the world Taxes from the rest of the world 12.3 0.6
Contributions for social insurance Contributions for social insurance 949.1 42.7
Interest receipts and rents and royalties Interest receipts and rents and royalties 48.2 2.2
Current transfer receipts from business and persons Current transfer receipts from business and persons 68.1 3.1
Current surplus of government enterprises Current surplus of government enterprises - 4.9 - 0.2
Total 2,224.9 100.0
Current Expenditures Current Expenditures Current Expenditures
Consumption expenditures Consumption expenditures 986.4 28.6
Transfer payments to persons Transfer payments to persons 1596.1 46.2
Transfer payments to the rest of the world Transfer payments to the rest of the world 61.7 1.8
Grants-in-aid to state and local governments Grants-in-aid to state and local governments 476.6 13.8
Interest payments Interest payments 272.3 7.9
Subsidies Subsidies 58.2 1.7
Total 3,451.3 100.0
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) - 1,226.4
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The Federal Budget
The Budget in 2009
federal surplus () or deficit (-) Federal
government receipts minus expenditures.
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The Federal Budget
Fiscal Policy Since 1993 The Clinton, Bush, and
Obama Administrations
? FIGURE 9.4 Federal Personal Income Taxes as a
Percentage of Taxable Income, 1993 I2010 I
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The Federal Budget
Fiscal Policy Since 1993 The Clinton, Bush, and
Obama Administrations
? 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 I2010 I
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The Federal Budget
Fiscal Policy Since 1993 The Clinton, Bush, and
Obama Administrations
? FIGURE 9.6 The Federal Government Surplus ()
or Deficit () as a Percentage of GDP, 1993
I2010 I
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The Federal Budget
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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The Federal Budget
The Federal Government Debt
? FIGURE 9.7 The Federal Government Debt as a
Percentage of GDP, 1993 I2010 1
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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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E C O N O M I C S I N P R A C T I C E
Governments Disagree on How Much More Spending Is
Needed
The U.S. economy is intertwined with the rest of
the world. For that reason, U.S. government
leaders are concerned not only with their own
fiscal policies but also with those of other
governments (and vice versa). President Obama
was among the strongest advocates of additional
stimulus by governments in a June 2010 summit of
the G-20.
Spending Fight at G-20 The Wall Street Journal
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The Economys Influence on the Government Budget
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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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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CHAPTER 9 APPENDIX A
Deriving the Fiscal Policy Multipliers
The Balanced-Budget Multiplier

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

In a balanced-budget increase, ?G ?T so we can
substitute
net initial increase in spending ?G - ?G (MPC)
?G (1 - MPC)
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CHAPTER 9 APPENDIX A
Deriving the Fiscal Policy Multipliers
The Balanced-Budget Multiplier
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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CHAPTER 9 APPENDIX B
The Case in Which Tax Revenues Depend on Income
? 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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CHAPTER 9 APPENDIX B
The Case in Which Tax Revenues Depend on Incomes
The Government Spending and Tax Multipliers
Algebraically
Through substitution we get
Solving for Y
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CHAPTER 9 APPENDIX B
The Case in Which Tax Revenues Depend on Incomes
The Government Spending and Tax Multipliers
Algebraically
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