CASE  FAIR  OSTER MACROECONOMICS PRINCIPLES OF E L E V E N T H E D I T I O N CASE  FAIR  OSTER PEARSON Prepared by: Fernando Quijano w/Shelly Tefft

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 2012 Fiscal Policy Since 1993: The Clinton, Bush, and Obama Administrations The Federal Government Debt The Economy’s 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

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. Monetary policy.

disposable income ≡ total income − net taxes 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

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

budget deficit ≡ G − T C = a + bYd C = a + b(Y − T) 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 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.

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 + G d. G − T

Planned Investment 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.

The Determination of Equilibrium Output (Income) 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 Net Taxes T Disposable Income Yd ≡Y −T Consumption Spending C = 100 + .75 Yd Saving S Yd – C Planned Investment Spending I Government Purchases G Planned Aggregate Expenditure C + I + G Unplanned Inventory Change Y − (C + I + G) Adjustment to Disequi-librium 300 100 200 250 − 50 450 − 150 Output ↑ 500 400 600 − 100 700 550 50 750 900 800 Equilibrium 1,100 1,000 850 150 1,050 + 50 Output ↓ 1,300 1,200 + 100 1,500 1,400 1,150 1,350 + 150

Equilibrium occurs at Y = C + I + G = 900.  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: 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

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. S + T = I + G.

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

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 Net Taxes T Disposable Income Yd ≡Y −T Consumption Spending C = 100 + .75 Yd Saving S Yd – C Planned Investment Spending I Government Purchases G Planned Aggregate Expenditure C + I + G Unplanned Inventory Change Y − (C + I + G) Adjustment to Disequilibrium 300 100 200 250 - 50 150 500 - 200 Output ↑ 400 650 - 150 700 600 550 50 800 - 100 900 950 1,100 1,000 850 Equilibrium 1,300 1,200 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. 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.

Increasing government spending by 50 shifts the AE function up by 50.  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.

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:

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.

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 Net Taxes T Disposable Income Yd ≡Y − T Consumption Spending C = 100 + .75 Yd Planned Investment Spending I Government Purchases G Planned Aggregate Expenditure C + I + G Unplanned Inventory Change Y − (C + I + G) Adjustment to Disequilibrium 500 300 200 250 100 650 −150 Output ↑ 700 400 800 −100 900 600 550 950 −50 1,100 Equilibrium 1,300 1,000 850 1,250 + 50 Output ↓ 1,500 1,200 1,400 + 100

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. Equilibrium income would decrease by $200, or double the amount of the increase in T. 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. 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. Equilibrium income would decrease by $200, or double the amount of the increase in T. Nothing happens. Equilibrium income remains the same because the amount of government spending (G) is compensated by the amount of taxation (T).

Final Impact on Equilibrium Y TABLE 9.4 Summary of Fiscal Policy Multipliers Policy Stimulus Multiplier Final Impact on Equilibrium Y Government spending multiplier Increase or decrease in the level of government purchases: ∆G Tax multiplier Increase or decrease in the level of net taxes: ∆T Balanced-budget multiplier Simultaneous balanced-budget increase or decrease in the level of government purchases and net taxes: ∆G = ∆T 1

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.

The Federal Budget Because fiscal policy is the manipulation of items in the federal budget, that budget is relevant to our study of macroeconomics. federal budget The budget of the federal government. 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. All of the above.

The Budget in 2012 TABLE 9.5 Federal Government Receipts and Expenditures, 2012 (Billions of Dollars) Amount Percentage of Total Current receipts Personal income taxes 1,137.8 42.5 Excise taxes and customs duties 116.1 4.3 Corporate income taxes 373.7 14.0 Taxes from the rest of the world 17.3 0.6 Contributions for social insurance 934.8 35.0 Interest receipts and rents and royalties 53.4 2.0 Current transfer receipts from business and persons 59.2 2.2 Current surplus of government enterprises − 17.8 − 0.7 Total 2,674.5 100.0 Current expenditures Consumption expenditures 1,059.6 28.2 Transfer payments to persons 1,773.2 47.2 Transfer payments to the rest of the world 76.4 Grants-in-aid to state and local governments 468.0 12.5 Interest payments 318.5 8.5 Subsidies 60.4 1.6 3,756.1 Net federal government saving–surplus (+) or deficit (−) (Total current receipts − Total current expenditures) − 1,081.6 federal surplus (+) or deficit (−) Federal government receipts minus expenditures.

Fiscal Policy Since 1993: The Clinton, Bush, and Obama Administrations  FIGURE 9.4 Federal Personal Income Taxes as a Percentage of Taxable Income, 1993 I–2012 IV

 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. 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.

The U.S. Congress Fights about the Budget 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 How would you describe the views of the two people quoted on the benefits of government spending?

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.

 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. THINKING PRACTICALLY 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?

The Economy’s 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.

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 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 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.

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. 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.

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) 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

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):

The Balanced-Budget Multiplier It is easy to show formally that the balanced-budget multiplier = 1. initial increase in spending: − initial decrease in spending: = 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)

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.

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.

 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.

We know that Y = C + I + G. Through substitution we get The Government Spending and Tax Multipliers Algebraically We know that Y = C + I + G. Through substitution we get Solving for Y:

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