PowerPoint Lectures for Principles of Economics, 9e By Karl E. Case, Ray C. Fair & Sharon M. Oster ; ;

The Government and Fiscal Policy Prepared by: Fernando & Yvonn Quijano

24 The Government and Fiscal Policy PART V THE CORE OF MACROECONOMIC THEORY 24 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 2007 Fiscal Policy Since 1993: The Clinton and Bush Administrations The Federal Government Debt The Economy’s Influence on the Government Budget Tax Revenues Depend on the State of the Economy Some Government Expenditures Depend on the State of the Economy Automatic Stabilizers Fiscal Drag Full-Employment Budget Looking Ahead Appendix A: Deriving the Fiscal Policy Multipliers Appendix B: The Case in Which Tax Revenues Depend on Income

The Government and Fiscal Policy 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.

Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Yd)  FIGURE 24.1 Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income

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.

Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Yd) When government enters the picture, the aggregate income identity gets cut into three pieces: And aggregate expenditure (AE) equals:

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

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

Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Yd) Planned Investment The government can affect investment behavior through its tax treatment of depreciation and other tax policies.

Government in the Economy The Determination of Equilibrium Output (Income) Y = C + I + G TABLE 24.1 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 Output8 500 400 600 - 100 700 550 50 750 900 800 Equilibrium 1,100 1,000 850 150 1,050 + 50 Output9 1,300 1,200 + 100 1,500 1,400 1,150 1,350 + 150

Government in the Economy The Determination of Equilibrium Output (Income)  FIGURE 24.2 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: Government in the Economy The Determination of Equilibrium Output (Income) 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

Fiscal Policy at Work: Multiplier Effects The Government Spending Multiplier government spending multiplier The ratio of the change in the equilibrium level of output to a change in government spending.

Fiscal Policy at Work: Multiplier Effects The Government Spending Multiplier TABLE 24.2 Finding Equilibrium After a Government Spending Increase of 50 (G Has Increased from 100 in Table 24.1 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 Output8 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.

Fiscal Policy at Work: Multiplier Effects The Government Spending Multiplier  FIGURE 24.3 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.

Fiscal Policy at Work: Multiplier Effects The Tax Multiplier tax multiplier The ratio of change in the equilibrium level of output to a change in taxes.

Which of the following formulas shows the impact of a change in taxes on equilibrium income? a. Y = a + b(Y – T) + I + G b. Y = 1/(1 – b) * (a – bT + I + G) c. S + T = I + G d. – ∆T * (b/1 – b) e. C + S = I + G

Which of the following formulas shows the impact of a change in taxes on equilibrium income? a. Y = a + b(Y – T) + I + G b. Y = 1/(1 – b) * (a – bT + I + G) c. S + T = I + G d. – ∆T * (b/1 – b) e. C + S = I + G

Fiscal Policy at Work: Multiplier Effects 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.

Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier TABLE 24.3 Finding Equilibrium After a Balanced-Budget Increase in G and T of 200 Each (Both G and T Have Increased from 100 in Table 24.1 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 Output8 700 400 800 - 100 900 600 550 950 - 50 1,100 Equilibrium 1,300 1,000 850 1,250 + 50 Output9 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 Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier TABLE 24.4 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

The Federal Budget federal budget The budget of the federal government. The “budget” is really three different budgets. First, it is a political document that dispenses favors to certain groups or regions and places burdens on others. Second, it is a reflection of goals the government wants to achieve. Third, the budget may be an embodiment of some beliefs about how (if at all) the government should manage the macroeconomy.

The Federal Budget The Budget in 2007 TABLE 24.5 Federal Government Receipts and Expenditures, 2007 (Billions of Dollars) Amount Percentage Of Total Receipts Personal income taxes 1,162.1 43.5 Excise taxes and customs duties 99.9 3.7 Corporate income taxes 380.8 14.3 Taxes from the rest of the world 13.4 0.5 Contributions for social insurance 953.0 35.7 Interest receipts and rents and royalties 25.1 0.9 Current transfer receipts from business and persons 39.4 1.5 Current surplus of government enterprises − 2.3 − 0.0 Total 2,671.4 100.0 Current Expenditures Consumption expenditures 856.0 29.6 Transfer payments to persons 1,270.7 43.9 Transfer payments to the rest of the world 38.6 1.3 Grants-in-aid to state and local governments 377.5 13.1 Interest payments 302.4 10.5 Subsidies 46.7 1.6 2,892.0 Net federal government saving—surplus (+) or deficit (−) (Total current receipts − Total current expenditures) − 220.6 Source: U.S. Department of Commerce, Bureau of Economic Analysis.

The Federal Budget The Budget in 2007 federal surplus (+) or deficit () Federal government receipts minus expenditures.

The Federal Budget Fiscal Policy Since 1993: The Clinton and Bush Administrations  FIGURE 24.4 Federal Personal Income Taxes as a Percentage of Taxable Income, 1993 I–2007 IV

The Federal Budget Fiscal Policy Since 1993: The Clinton and Bush Administrations  FIGURE 24.5 Federal Government Consumption Expenditures as a Percentage of GDP and Federal Transfer Payments and Grants-in-Aid as a Percentage of GDP, 1993 I–2007 IV

The Federal Budget Fiscal Policy Since 1993: The Clinton and Bush Administrations  FIGURE 24.6 The Federal Government Surplus (+) or Deficit (–) as a Percentage of GDP, 1993 I–2007 IV

The federal budget can be conceived as: a. A political document that dispenses favors to some groups and places burdens on others. b. A reflection of goals the government wants to achieve. c. An embodiment of some beliefs about how (if at all) the government should manage the macroeconomy. d. All of the above.

The federal budget can be conceived as: a. A political document that dispenses favors to some groups and places burdens on others. b. A reflection of goals the government wants to achieve. c. An embodiment of some beliefs about how (if at all) the government should manage the macroeconomy. d. All of the above.

The Federal Budget 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.

The Federal Budget The Federal Government Debt  FIGURE 24.7 The Federal Government Debt as a Percentage of GDP, 1993 I–2007 IV

The Economy’s Influence on the Government Budget Tax Revenues Depend on the State of the Economy Tax revenue, on the other hand, depends on taxable income, and income depends on the state of the economy, which the government does not completely control. Some Government Expenditures Depend on the State of the Economy Transfer payments tend to go down automatically during an expansion. Inflation often picks up when the economy is expanding. This can lead the government to spend more than it had planned to spend. Any change in the interest rate changes government interest payments.

After a large deficit buildup in the 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 administration. d. Was an even larger deficit, as a percent of GDP, in 2003 than it was in 1983.

After a large deficit buildup in the 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 administration. d. Was an even larger deficit, as a percent of GDP, in 2003 than it was in 1983.

Fiscal Policy In 2008 The Economy’s Influence on the Government Budget Some Government Expenditures Depend on the State of the Economy Congress Approves Economic-Stimulus Bill Wall Street Journal

The Economy’s Influence on the Government Budget Automatic Stabilizers 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 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.

The Economy’s Influence on the Government Budget 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.

REVIEW TERMS AND CONCEPTS 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 government: Y = C + I + G 5. Saving/investment approach to equilibrium in an economy with government: S + T = I + G 6. Government spending multiplier ≡ 7. Tax multiplier ≡ 8. Balanced-budget multiplier ≡ 1

A P P E N D I X A DERIVING THE FISCAL POLICY MULTIPLIERS THE GOVERNMENT SPENDING AND TAX MULTIPLIERS

net initial increase in spending: A P P E N D I X A DERIVING THE FISCAL POLICY MULTIPLIERS THE BALANCED-BUDGET MULTIPLIER The balanced-budget multiplier is found by combining the effects of government spending and taxes: increase in spending: - decrease in spending: = net increase in spending In a balanced-budget increase, ΔG = ΔT; so we can substitute: net initial increase in spending: ΔG − ΔG (MPC) = ΔG (1 − MPC)

A P P E N D I X A DERIVING THE FISCAL POLICY MULTIPLIERS THE BALANCED-BUDGET MULTIPLIER Because MPS = (1 − MPC), the net initial increase in spending is: ΔG (MPS) We can now apply the expenditure multiplier to this net initial increase in spending:

A P P E N D I X B THE CASE IN WHICH TAX REVENUES DEPEND ON INCOME  FIGURE 24B.1 The Tax Function

A P P E N D I X B THE CASE IN WHICH TAX REVENUES DEPEND ON INCOME  FIGURE 24B.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.

A P P E N D I X B THE CASE IN WHICH TAX REVENUES DEPEND ON INCOME THE GOVERNMENT SPENDING AND TAX MULTIPLIERS ALGEBRAICALLY