1 of 42 part iii the core of macroeconomic theory © 2012 pearson education, inc. publishing as...

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© 2012 Pearson Education, Inc. Publishing as Prentice Hall Prepared by: Fernando Quijano & Shelly Tefft

CASE FAIR OSTER

P R I N C I P L E S O F

MACROECONOMICST E N T H E D I T I O N

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© 2012 Pearson Education, Inc. Publishing as Prentice Hall

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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 2009Fiscal 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

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fiscal policy The government’s spending and taxing policies.

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

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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)

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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,

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).

GICAE

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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



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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.



Adding Taxes to the Consumption Function

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The government can affect investment behavior through its tax treatment of depreciation and other tax policies.



Planned Investment

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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)

Y

NetTaxes

T

DisposableIncomeYd ≡Y T

ConsumptionSpending

C = 100 + .75 Yd

SavingS

Yd – C

PlannedInvestmentSpending

I

GovernmentPurchases

G

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 ↓



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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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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

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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

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1government spending multiplier

MPS

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


The Government Spending Multiplier

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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)

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

Output(Income)

Y

NetTaxes

T


ConsumptionSpending

C = 100 + .75 Yd

SavingS

Yd – C


I

GovernmentPurchases

G

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 ↓



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FIGURE 9.3 The GovernmentSpending MultiplierIncreasing 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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tax multiplier The ratio of change in the equilibrium level of output to a change in taxes.

tax multiplier MPC

MPS

YM P S

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

1

1( )

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:

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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

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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)

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

Output(Income)

Y

NetTaxes

T


ConsumptionSpending

C = 100 + .75 Yd


I

GovernmentPurchases

G

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 ↓



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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 purchasesand net taxes: ∆G = ∆T

1

1

M P S

M P C

M P S

1 G

MPS

MPC

TMPS

G



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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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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.

The Federal Budget

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TABLE 9.5 Federal Government Receipts and Expenditures, 2009 (Billions of Dollars)

Amount Percentage of TotalCurrent receipts

Personal income taxes 828.7 37.2Excise taxes and customs duties 92.3 4.1Corporate income taxes 231.0 10.4Taxes from the rest of the world 12.3 0.6Contributions for social insurance 949.1 42.7Interest receipts and rents and royalties 48.2 2.2Current transfer receipts from business and persons 68.1 3.1Current surplus of government enterprises − 4.9 − 0.2

Total 2,224.9 100.0Current Expenditures

Consumption expenditures 986.4 28.6Transfer payments to persons 1596.1 46.2Transfer payments to the rest of the world 61.7 1.8Grants-in-aid to state and local governments 476.6 13.8Interest payments 272.3 7.9Subsidies 58.2 1.7

Total 3,451.3 100.0Net federal government saving—surplus (+) or deficit (−)

(Total current receipts − Total current expenditures) − 1,226.4

The Federal Budget

The Budget in 2009

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

The Federal Budget

The Budget in 2009

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FIGURE 9.4 Federal Personal Income Taxes as a Percentage of Taxable Income, 1993 I–2010 I

The Federal Budget

Fiscal Policy Since 1993: The Clinton, Bush, and Obama Administrations

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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 I–2010 I

The Federal Budget


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FIGURE 9.6 The Federal Government Surplus (+) or Deficit (–) as a Percentage of GDP, 1993 I–2010 I

The Federal Budget


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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 Budget

The Federal Government Debt

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FIGURE 9.7 The Federal Government Debt as a Percentage of GDP, 1993 I–2010 1

The Federal Budget

The Federal Government Debt

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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.


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.

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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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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

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

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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

1. Disposable income Yd ≡ Y − T

2. AE ≡ C + I + G

3. Government budget deficit ≡ G − T

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

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

6. Government spending multiplier ≡

7. Tax multiplier ≡

8. Balanced-budget multiplier ≡ 1

MPC

MPS

MPS

1

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

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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

)(1

1bTGIa

b Y

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

Gincrease in spending:( )C T MPC − decrease in spending:( )G T MPC = net increase in spending

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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1( )Y G MPS G

MPS

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:

MPS

1




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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TYYd

)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.

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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

GICY

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

4505.

5.450

1001002515075.100

Y

YY

YYY


The Case in Which Tax Revenues Depend on Income

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C a b Y T ( )

0C a bY bT btY

0( )C a b Y T tY

0Y a bY bT btY I G

C

Yb b t

a I G bT

1

1 0( )


The Government Spending and Tax Multipliers Algebraically

The Case in Which Tax Revenues Depend on Incomes

Through substitution we get

Solving for Y:

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1

1 b bt


The Government Spending and Tax Multipliers Algebraically

The Case in Which Tax Revenues Depend on Incomes

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

btb

b

1

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Documents

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income slide

budget deficit g t government

economy government purchases

income y d total income

disposable income y