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© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

The Governmentand Fiscal Policy

Appendix A: Deriving the Fiscal Policy MultipliersAppendix B: The Case in Which Tax Revenues

Depend on Income

Prepared by: Fernando QuijanoPrepared by: Fernando Quijano and Yvonn Quijano and Yvonn Quijano

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2 of 35© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

Government in the Economy

• Nothing arouses as much controversy as the role of government in the economy.

• Government can affect the macroeconomy in two ways:

• Fiscal policy is the manipulation of government spending and taxation.

• Monetary policy refers to the behavior of the Federal Reserve regarding the nation’s money supply.

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Government in the Economy

• Discretionary fiscal policy refers to deliberate changes in taxes or spending.

• The government can not control certain aspects of the economy related to fiscal policy. For example:

• The government can control tax rates but not tax revenue. Tax revenue depends on household income and the size of corporate profits.

• Government spending depends on government decisions and the state of the economy.

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Net Taxes (T), and Disposable Income (Yd)

• Net taxes are taxes paid by firms and households to the government minus transfer payments made to households by the government.

• Disposable, or after-tax, income (Yd ) equals total income minus taxes.

Y Y Td

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

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

• When government enters the picture, the aggregate income identity gets cut into three pieces:

Y Y Td

Y C Sd

Y T C S Y C S T

• And aggregate expenditure (AE) equals:

A E C I G

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The Budget Deficit

• A government’s budget deficit is the difference between what it spends (G) and what it collects in taxes (T) in a given period:

B udget def G Ticit

• If G exceeds T, the government must borrow from the public to finance the deficit. It does so by selling Treasury bonds and bills. In this case, a part of household saving (S) goes to the government.

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Adding Taxes to theConsumption Function

• The aggregate consumption function is now a function of disposable, or after-tax, income.

C a bYd

Y Y Td

C a b Y T ( )

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Equilibrium Output: Y = C + I + G

Finding Equilibrium for I = 100, G = 100, and T = 100(All Figures in Billions of Dollars)

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

OUTPUT(INCOME)

Y

NETTAXES

T

DISPOSABLEINCOME

Yd Y T

CONSUMPTIONSPENDING

(C = 100 + .75 Yd)

SAVINGS

(Yd – C)

PLANNEDINVESTMENT

SPENDINGI

GOVERNMENTPURCHASES

G

PLANNEDAGGREGATE

EXPENDITURE C + I + G

UNPLANNEDINVENTORY

CHANGEY (C + I + G)

ADJUSTMENTTO

DISEQUILIBRIUM

300 100 200 250 50 100 100 450 150 Output500 100 400 400 0 100 100 600 100 Output700 100 600 550 50 100 100 750 50 Output900 100 800 700 100 100 100 900 0 Equilibrium

1,100 100 1,000 850 150 100 100 1,050 + 50 Output1,300 100 1,200 1,000 200 100 100 1,200 + 100 Output1,500 100 1,400 1,150 250 100 100 1,350 + 150 Output

C Yd 1 0 0 7 5. C Y T 1 0 0 7 5. ( )

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Finding EquilibriumOutput/Income Graphically

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The Leakages/Injections Approach

• Taxes (T) are a leakage from the flow of income. Saving (S) is also a leakage.

• In equilibrium, aggregate output (income) (Y) equals planned aggregate expenditure (AE), and leakages (S + T) must equal planned injections (I + G). Algebraically,

S T I G

A E C I G Y C S T

C S T C I G

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The Government Spending Multiplier

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

G overnm en t m ultip lierM P S

spend ing 1

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Finding Equilibrium After a $50 Billion Government Spending Increase(All Figures in Billions of Dollars; G Has Increased From 100 in Table 25.1 to 150 Here)

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

OUTPUT(INCOME)

Y

NETTAXES

T

DISPOSABLEINCOME

Yd Y T

CONSUMPTIONSPENDING

(C = 100 + .75 Yd)

SAVINGS

(Yd – C)

PLANNEDINVESTMENT

SPENDINGI

GOVERNMENTPURCHASES

G

PLANNEDAGGREGATE


UNPLANNEDINVENTORY

CHANGEY (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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The Tax Multiplier

• A tax cut increases disposable income, and leads to added consumption spending. Income will increase by a multiple of the decrease in taxes.

• A tax cut has no direct impact on spending. The multiplier for a change in taxes is smaller than the multiplier for a change in government spending.

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The Tax Multiplier

YM P S

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

1

Y T M P CM P S

TM P C

M P S

( )

1

T ax m ultipM P C

M P Slier

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The Balanced-Budget Multiplier

• The balanced-budget multiplier is 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.

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The Balanced-Budget Multiplier

Finding Equilibrium After a $200 Billion Balanced Budget Increase in G and T(All Figures in Billions of Dollars; G and T Have Increased From 100 in Table 25.1 to 300 Here)

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

OUTPUT(INCOME)

Y

NETTAXES

T

DISPOSABLEINCOMEYd Y T

CONSUMPTIONSPENDING

(C = 100 + .75 Yd)

PLANNEDINVESTMENT

SPENDINGI

GOVERNMENTPURCHASES

G

PLANNEDAGGREGATE


UNPLANNEDINVENTORY

CHANGEY (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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Fiscal Policy Multipliers

Summary of Fiscal Policy Multipliers

POLICY STIMULUS MULTIPLIERFINAL IMPACT ON

EQUILIBRIUM Y

Government-spendingmultiplier

Increase or decrease in thelevel of governmentpurchases:

Tax multiplier Increase or decrease in thelevel of net taxes:

Balanced-budgetmultiplier

Simultaneous balanced-budgetincrease or decrease in thelevel of government purchasesand net taxes:

1

1

M P S

M P C

M P S

GM P S

1

TM P C

M P S

G

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The Federal Budget

• The federal budget is the budget of the federal government.

• The difference between the federal government’s receipts and its expenditures is the federal surplus (+) or deficit (-).

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The Federal Budget

Federal Government Receipts and Expenditures, 2000 (Billions of Dollars)

AMOUNTPERCENTAGE

OF TOTAL

ReceiptsPersonal taxes 1,010.1 49.6Corporate taxes 193.2 9.5Indirect business taxes 111.0 5.5Contributions for social insurance 720.6 35.4

Total 2,034.9 100.0Current Expenditures

Consumption 514.1 26.9Transfer payments 831.9 43.6Grants-in-aid to state and local governments 274.2 14.4Net interest payments 236.9 12.4Net subsidies of government enterprises 52.5 2.7

Total 1,909.6 100.0Current Surplus (+) or deficit () (Receipts Current Expenditures) + 125.3Source: U.S. Department of Commerce, Bureau of Economic Analysis.

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The Federal Government Surplus (+) or Deficit (-) as a Percentage of GDP, 1970 I2003 II

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The Debt

• The federal debt is the total amount owed by the federal government. The debt is the sum of all accumulated deficits minus surpluses over time.

• Some of the federal debt is held by the U.S. government itself and some by private individuals. The privately held federal debt is the private (non-government-owned) portion of the federal debt.

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The Federal Government Debt as a Percentage of GDP, 1970 I2003 II

The percentage began to fall in the mid 1990s.

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The Economy’s Influenceon the Government Budget

• Automatic stabilizers are 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.

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• Fiscal drag is 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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• The full-employment budget is what the federal budget would be if the economy were producing at a full-employment level of output.

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• The cyclical deficit is the deficit that occurs because of a downturn in the business cycle.

• The structural deficit is the deficit that remains at full employment.

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Review Terms and Concepts

automatic stabilizers

balanced-budget multiplierbalanced-budget multiplier

budget deficitbudget deficit

cyclical deficitcyclical deficit

discretionary fiscal policydiscretionary fiscal policy

disposable, or after-tax, disposable, or after-tax, incomeincome

federal budgetfederal budget

federal debtfederal debt

federal surplus (+) or deficit (-)federal surplus (+) or deficit (-)

fiscal dragfiscal drag

fiscal policyfiscal policy

full-employment budgetfull-employment budget

government spending multipliergovernment spending multiplier

monetary policymonetary policy

net taxesnet taxes

privately held federal debtprivately held federal debt

structural deficitstructural deficit

tax multipliertax multiplier

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Appendix A:Deriving the Fiscal Policy Multipliers

The government spending and tax multipliers algebraically:

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

1( )

1Y a bT I G

b

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Appendix A:Deriving the Fiscal Policy Multipliers

• The balanced-budget multiplier is found by combining the effects of government spending and taxes:

G T

1( )Y G MPS G

MPS

• The balanced-budget multiplier equals one. An increase in G and T by one dollar each causes a one-dollar increase in Y.

Gincrease in spending:

( )C T MPC - decrease in spending:

( )G T MPC = net increase in spending

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Appendix B: The Case In WhichTax Revenues Depend on Income

Y C I G

dY Y T

200 1 3T Y

T T tY 0

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dC a bY

dY Y T 200 1 3T Y

( 200 1 3 )dY Y Y

200 1 3 )dY Y Y

100 .75( 200 1 3 )C Y Y

900Y Y C I G 100I 100G

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Yb bt

a bT I G

1

1 0( )


The Government Spending and Tax Multipliers Algebraically:

( )C a b Y T

0C a bY bT btY 0( )C a b Y T tY

0Y a bY bT btY I G Y C I G

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Yb bt

a bT I G

1

1 0( )


• The government spending and tax multipliers when taxes are a function of income are derived as follows:

Y C I G C a b Y T ( )

0C a bY bT btY 0( )C a b Y T tY

Y a bY bT btY I G 0

Y bY btY a bT I G 0

Y b b t a bT I G( )1 0

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Business

r e t p

yd y t yd c

h cy t c

yd c y c

government purchases

b yd yd y t

h cadding net taxes

ekarl case