21 - Savvas

C H A P T E R

C H A P T E R

C H A P T E R 21

© 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 IncomePrepared by: Fernando QuijanoPrepared by: Fernando Quijano

and Yvonn Quijanoand Yvonn Quijano

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C H A P T E R 21: The Government and Fiscal Policy


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:

AE 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:

Budget 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

Output9+ 1501,3501001002501,1501,4001001,500Output9+ 1001,2001001002001,0001,2001001,300Output9+ 501,0501001001508501,0001001,100

Equilibrium0900100100100700800100900Output8− 5075010010050550600100700Output8− 1006001001000400400100500Output8− 150450100100− 50250200100300

ADJUSTMENTTO

DISEQUILIBRIUM

UNPLANNEDINVENTORY

CHANGEY − (C + I + G)

PLANNEDAGGREGATE

EXPENDITUREC + I + G

GOVERNMENTPURCHASES

G

PLANNEDINVESTMENT

SPENDINGI

SAVINGS

(Yd – C)

CONSUMPTIONSPENDING

(C = 100 + .75 Yd)

DISPOSABLEINCOME

Yd / Y − T

NETTAXES

T

OUTPUT(INCOME)

Y

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

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

C Yd= +100 75. C Y T= + −100 75. ( )

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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+ = +

AE 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.

Government multiplierMPS

spending =1

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Output9+ 501,2501501002001,0001,2001001,300

Equilibrium01,1001501001508501,0001001,100

Output8− 50950150100100700800100900

Output8− 10080015010050550600100700

Output8− 1506501501000400400100500

Output8− 200500150100− 50250200100300

ADJUSTMENTTO

DISEQUILIBRIUM

UNPLANNEDINVENTORY


PLANNEDAGGREGATE


GOVERNMENTPURCHASES

G

PLANNEDINVESTMENT

SPENDINGI

SAVINGS

(Yd – C)

CONSUMPTIONSPENDING

(C = 100 + .75 Yd)

DISPOSABLEINCOME

Yd / Y − T

NETTAXES

T

OUTPUT(INCOME)

Y

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

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)

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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

∆YMPS

=

(initial increase in aggregate expenditure)

1×

∆ ∆ ∆Y T MPCMPS

TMPCMPS

= − × ×

= − ×

( )

1

Tax multipMPCMPS

lier ≡ −

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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

Output9+ 1001,4003001001,0001,2003001,500

Output9+ 501,2503001008501,0003001,300

Equilibrium01,1003001007008003001,100

Output8− 50950300100550600300900

Output8− 100800300100400400300700

Output8− 150650300100250200300500

ADJUSTMENTTO

DISEQUILIBRIUM

UNPLANNEDINVENTORY


PLANNEDAGGREGATE


GOVERNMENTPURCHASES

G

PLANNEDINVESTMENT

SPENDINGI

CONSUMPTIONSPENDING

(C = 100 + .75 Yd)

DISPOSABLEINCOME

Yd / Y − T

NETTAXES

T

OUTPUT(INCOME)

Y

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

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)

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Fiscal Policy Multipliers

1Simultaneous balanced-budgetincrease or decrease in thelevel of government purchasesand net taxes:

Balanced-budgetmultiplier

Increase or decrease in thelevel of net taxes:

Tax multiplier

Increase or decrease in thelevel of governmentpurchases:

Government-spendingmultiplier

FINAL IMPACT ONEQUILIBRIUM YMULTIPLIERPOLICY STIMULUS

Summary of Fiscal Policy Multipliers

1MPS

− MPCMPS

∆GMPS

⋅1

∆TMPC

MPS⋅−

∆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

Total

Total

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

100.01,909.62.752.5Net subsidies of government enterprises

12.4236.9Net interest payments14.4274.2Grants-in-aid to state and local governments43.6831.9Transfer payments26.9514.1Consumption

Current Expenditures100.02,034.935.4720.6Contributions for social insurance

5.5111.0Indirect business taxes9.5193.2Corporate taxes

49.61,010.1Personal taxesReceipts

PERCENTAGE OF TOTALAMOUNT

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

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The Federal Government Surplus (+) or Deficit (-) as a Percentage of GDP, 1970 I−2003 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 I−2003 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 budgetis 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 stabilizersautomatic stabilizers

balancedbalanced--budget multiplierbudget multiplier

budget deficitbudget deficit

cyclical deficitcyclical deficit

discretionary fiscal policydiscretionary fiscal policy

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

federal budgetfederal budget

federal debtfederal debt

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

fiscal dragfiscal drag

fiscal policyfiscal policy

fullfull--employment budgetemployment 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 ( )1

Y a bT I Gb

= − + +−

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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 GMPS

∆ = ∆ = ∆

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

G∆increase 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 bt a bT I G( )1 0− + = − + +

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21 - Savvas