CASE FAIR OSTER

PRINCIPLES OF

MACROECONOMICSE L E V E N T H E D I T I O N

PEARSONPrepared by: Fernando Quijano w/Shelly Tefft

CHAPTER OUTLINE

9The Government and Fiscal Policy

Government in the EconomyGovernment Purchases (G), Net Taxes (T), and Disposable Income (Yd)

The Determination of Equilibrium Output (Income)

Fiscal Policy at Work: Multiplier EffectsThe Government Spending MultiplierThe Tax MultiplierThe Balanced-Budget Multiplier

The Federal BudgetThe Budget in 2012Fiscal Policy Since 1993: The Clinton, Bush, and Obama AdministrationsThe Federal Government Debt

The Economy’s Influence on the Government Budget

Automatic Stabilizers and DestabilizersFull-Employment Budget

Looking Ahead

Appendix A: Deriving the Fiscal Policy Multipliers

Appendix B: The Case in Which Tax Revenues Depend on Income

fiscal policy The government’s spending and taxing policies.

monetary policy The behavior of the Federal Reserve concerning the nation’s money supply.

The behavior of the Federal Reserve concerning the nation’s money supply is called:

a. Discretionary fiscal policy.

b. Automatic fiscal policy.

c. Budgetary policy.

d. Monetary policy.

The behavior of the Federal Reserve concerning the nation’s money supply is called:

a. Discretionary fiscal policy.

b. Automatic fiscal policy.

c. Budgetary policy.

d.d. Monetary policy.Monetary policy.

discretionary fiscal policy Changes in taxes or spending that are the result of deliberate changes in government policy.

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

Government in the Economy

Government Purchases (G), Net Taxes (T), and Disposable Income (Yd)

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.

Over which of the following categories does the government have more control?

a. Tax revenue.

b. Government expenditures.

c.c. Tax rates.Tax rates.

d. The size of corporate profits.

FIGURE 9.1 Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income

The disposable income (Yd) of households must end up as either consumption (C) or saving (S). Thus,

Y C Sd

Y T C S

Y C S T

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).

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.

Select the best answer. Households use their disposable income (Yd) to do the following:

a. Consume.

b.b. Consume and save.Consume and save.

c. Consume, save, and pay taxes.

d. Consume, save, pay taxes, and buy imports.

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

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

C = a + b(Y − T)

Our consumption function now has consumption depending on disposable income instead of before-tax income.

Adding Taxes to the Consumption Function

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

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 + GC + I + G

d. G − T

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.

Planned Investment

Y = C + I + G

TABLE 9.1 Finding Equilibrium for I = 100, G = 100, and T = 100

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

Output(Income)

NetTaxes

DisposableIncomeYd ≡Y −T

ConsumptionSpending

C = 100 + .75 Yd

SavingS

Yd – C

PlannedInvestmentSpending

GovernmentPurchases

PlannedAggregate

Expenditure C + I + G

UnplannedInventoryChange

Y − (C + I + G)

Adjustmentto Disequi-

librium

300 100 200 250 − 50 100 100 450 − 150 Output ↑

500 100 400 400 0 100 100 600 − 100 Output ↑

700 100 600 550 50 100 100 750 − 50 Output ↑

900 100 800 700 100 100 100 900 0 Equilibrium

1,100 100 1,000 850 150 100 100 1,050 + 50 Output ↓

1,300 100 1,200 1,000 200 100 100 1,200 + 100 Output ↓

1,500 100 1,400 1,150 250 100 100 1,350 + 150 Output ↓

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.

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

The Saving/Investment Approach to Equilibrium

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.

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.d. S + T = I + GS + T = I + G..

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

Fiscal Policy at Work: Multiplier Effects

government spending multiplier The ratio of the change in the equilibrium level of output to a change in government spending.

The Government Spending Multiplier

MPCMPS

11multiplier spending government

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)

NetTaxes

DisposableIncomeYd ≡Y −T

ConsumptionSpending

C = 100 + .75 Yd

SavingS

Yd – C

GovernmentPurchases

PlannedAggregate

Y − (C + I + G)

Adjustmentto

Disequilibrium

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 ↓

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.

How much of an increase in government spending would be required to generate a $200 billion increase in the equilibrium level of output?

a.a. An amount less than $200 billion in government An amount less than $200 billion in government spending.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.

FIGURE 9.3 The GovernmentSpending 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.

tax multiplier The ratio of change in the equilibrium level of output to a change in taxes.

tax multiplier MPC

YM P S

(in itia l in crease in ag g reg a te ex p en d itu re )

MPCY T MPC T

MPS MPS

The Tax Multiplier

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:

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.

1balanced-budget multiplier

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)

(1) (2) (3) (4) (5) (6) (7) (8) (9)

Output(Income)

NetTaxes

DisposableIncome

Yd ≡Y − T

ConsumptionSpending

C = 100 + .75 Yd

GovernmentPurchases

PlannedAggregate

Y − (C + I + G)

Adjustmentto

Disequilibrium

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 ↓

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.

c.Equilibrium income would decrease by $200, or double the amount of the increase in T.

d.Nothing happens. Equilibrium income remains the same because the amount of government spending (G) is compensated by the amount of taxation (T).

What happens when there is a simultaneous increase in government spending of $100 and a lump-sum tax of $100?

a.a. Equilibrium income would increase by $100, or the Equilibrium income would increase by $100, or the amount of increase in amount of increase in GG..

b. Equilibrium income would decrease by $100, or the amount of increase in T.

c.Equilibrium income would decrease by $200, or double the amount of the increase in T.

d.Nothing happens. Equilibrium income remains the same because the amount of government spending (G) is compensated by the amount of taxation (T).

TABLE 9.4 Summary of Fiscal Policy Multipliers

Policy Stimulus MultiplierFinal 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

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.

federal budget The budget of the federal government.

The Federal Budget

Because fiscal policy is the manipulation of items in the federal budget, that budget is relevant to our study of macroeconomics.

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.

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.

The federal budget incorporates:

a. Plans for government spending.

b. Sources of government revenue.

c. Social, political, and economic forces.

d.d. All of the above.All of the above.

TABLE 9.5 Federal Government Receipts and Expenditures, 2012 (Billions of Dollars)

Amount Percentage of TotalCurrent receipts

Personal income taxes 1,137.8 42.5Excise taxes and customs duties 116.1 4.3Corporate income taxes 373.7 14.0Taxes from the rest of the world 17.3 0.6Contributions for social insurance 934.8 35.0Interest receipts and rents and royalties 53.4 2.0Current transfer receipts from business and persons 59.2 2.2Current surplus of government enterprises − 17.8 − 0.7

Total 2,674.5 100.0Current expenditures

Consumption expenditures 1,059.6 28.2Transfer payments to persons 1,773.2 47.2Transfer payments to the rest of the world 76.4 2.0Grants-in-aid to state and local governments 468.0 12.5Interest payments 318.5 8.5Subsidies 60.4 1.6

Total 3,756.1 100.0Net federal government saving–surplus (+) or deficit (−)

(Total current receipts − Total current expenditures) − 1,081.6

The Budget in 2012

federal surplus (+) or deficit (−) Federal government receipts minus expenditures.

FIGURE 9.4 Federal Personal Income Taxes as a Percentage of Taxable Income, 1993 I–2012 IV

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 I–2012 IV

FIGURE 9.6 The Federal Government Surplus (+) or Deficit (−) as a Percentage of GDP, 1993 I–2012 IV

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.

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.b. Turned into a surplus during the two Clinton Turned into a surplus during the two Clinton administrations.administrations.

c. Was vastly diminished during the G.W. Bush administrations.

d. Was virtually eliminated by the Obama administration.

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 Ryan’s bill: “This budget would not only jeopardize seniors, families and the most vulnerable in our society, it would also destroy jobs and put our nation’s 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

1.How would you describe the views of the two people quoted on the benefits of government spending?

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.

The Federal Government Debt

FIGURE 9.7 The Federal Government Debt as a Percentage of GDP, 1993 I–2012 IV

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.

1.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?

1.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?

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.

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.

The Economy’s Influence on the Government Budget

Automatic Stabilizers and Destabilizers

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.

Which of the following statements is correct about the government’s 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.

Which of the following statements is correct about the government’s 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 The government does not have complete control of either the revenue side or the expenditure side of the budget.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.

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.

Full-Employment Budget

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.

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.d. Equal to the structural deficit.Equal to the structural deficit.

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 policy—the government’s other major tool for influencing the economy.

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)

privately held federal debt

structural deficit

tax multiplier

Disposable income Yd ≡ Y − T

AE ≡ C + I + G

Government budget deficit ≡ G − T

Equilibrium in an economy with a government: Y = C + I + G

Saving/investment approach to equilibrium in an economy with a government: S + T = I + G

Government spending multiplier

7. Tax multiplier ≡

8. Balanced-budget multiplier ≡ 1

MPCMPS

R E V I E W T E R M S A N D C O N C E P T S

Y C I G

C a b Y T ( )

Y a b Y T I G ( )

Y a bY bT I G

Y bY a I G bT Y b a I G bT( )1

1bTGIa

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):

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

Ginitial increase in spending:( )C T MPC − initial decrease in spending:

( )G T MPC = net initial increase in spending

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)

The Balanced-Budget Multiplier

1( )Y G MPS G

Because MPS = (1 − MPC), the net initial increase in spending is:

∆G (MPS)

We can now apply the expenditure multiplier to this net initial increase in spending:

Thus, the final total increase in the equilibrium level of Y is just equal to the initial balanced increase in G and T.

)3/1200( YYYd

YYYd 3/1200

dYC 75.100

)3/1200(75.100 YYC

FIGURE 9B.1 The Tax Function

CHAPTER 9 APPENDIX B

The Case in Which Tax Revenues Depend on Income

This graph shows net taxes (taxes minus transfer payments) as a function of aggregate income.

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.

FIGURE 9B.2 Different Tax Systems

100 .75( 200 1/3 ) 100 100Y Y YI GC

1001002515075.100

C a b Y T ( )

0C a bY bT btY

0( )C a b Y T tY

0Y a bY bT btY I G

Yb b t

a I G bT

1 0( )

The Government Spending and Tax Multipliers Algebraically

We know that Y = C + I + G. Through substitution we get

Solving for Y:

1 b bt

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

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