The Government and Fiscal Policy CHAPTER OUTLINE Government in the Economy Fiscal Policy at Work: Multiplier Effects The Federal Budget The Economy’s Influence on the Government Budget Adapted from: Fernando & Yvonn Quijano

9.1 Government in the Economy fiscal policy The government’s spending and taxing policies. monetary policy The behavior of the Federal Reserve concerning the nation’s money supply. This chapter focuses on fiscal policy, or more specifically, discretionary fiscal policy (i.e. changes in taxes or spending that are the result of deliberate decisions by the government). However, in reality, taxes and spending often go up or down in response to changes in the economy.

disposable income ≡ total income − net taxes 9.1 Government in the Economy net taxes (T) Taxes paid by firms and households to the government minus transfer payments made to households by the government. disposable income ≡ total income − net taxes Yd ≡ Y − T At this stage, for simplicity, we assume T is a lump-sum tax. But in practice, tax revenues depend on income.

9.1 Government in the Economy When government enters the picture, the aggregate income identity gets cut into three pieces: and planned aggregate expenditure (AE) equals:

9.1 Government in the Economy Adding Taxes to the Consumption Function In a 2-sector economy, C = a + bY where b is MPC In a 3-sector economy, consumption depends on disposable income. C = a + bYd or C = a + b(Y − T)

9.1 Government in the Economy The Determination of Equilibrium Output (Income) At equilibrium, Y = AE Given that AE  C + I + G  Y = C + I + G If Y > C + I + G, there will be unplanned increases in inventories. Firms will respond by reducing output. As output falls, income falls, consumption falls, and so on, until equilibrium is restored. If Y < C + I + G, there will be unplanned reductions in inventories. Firms will respond by increasing output. As output increases, income rises, consumption rises, and so on, until equilibrium is restored,

9.1 Government in the Economy The Determination of Equilibrium Output (Income) 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 C = 100 + 0.75Yd = 100 + 0.75 (Y – 100) = 100 + 0.75Y – 75 = 25 + 0.75Y

9.1 Government in the Economy The Determination of Equilibrium Output (Income)  FIGURE 9.2 Finding Equilibrium Output/Income Graphically The new consumption function is C = 25 + 0.75Y. 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.

9.1 Government in the Economy The Determination of Equilibrium Output (Income) From Table 9.1, I = 100, G = 100, T = 100 (G = T is balance budget) C = 100 + 0.75Yd = 100 + 0.75 (Y – T) = 25 + 0.75Y At equilibrium, Y = C + I + G = (25 + 0.75Y) + 100 + 100 = 225 + 0.75Y 0.25Y = 225 Y = 225 / 0.25 = 900  The equilibrium level of output is 900.

9.1 Government in the Economy The Determination of Equilibrium Output (Income) The Saving/Investment Approach to Equilibrium At equilibrium, Y = AE Recall that Y  C + S + T AE  C + I + G Since Y = AE C + S + T = C + I + G S + T = I + G We will now use this approach to find equilibrium output based on the data from Table 9.1.

9.1 Government in the Economy The Determination of Equilibrium Output (Income) From Table 9.1, I = 100, G = 100, T = 100 (G = T is balance budget) Given that C = 100 + 0.75Yd Since Yd = C + S = (100 + 0.75Yd) + S S = -100 + 0.25Yd At equilibrium, S + T = I + G -100 + 0.25(Y – T) + T = I + G -100 + 0.25(Y – 100) + 100 = 100 + 100 0.25Y – 25 = 200 0.25Y = 225 Y = 225 / 0.25 = 900  The equilibrium level of output is 900.

9.2 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 (Y/G) Tax multiplier (Y/T) Balanced-budget multiplier We also assume that T is lump-sum tax.

9.2 Fiscal Policy at Work: Multiplier Effects (1) The Government Spending Multiplier When the government increases spending by 50 (G = 50), how much will equilibrium output Y increase? Using the same data as Table 9.1. I = 100, T = 100, but G = 150 (increased by 50). C = 100 + 0.75Yd = 25 + 0.75Y At equilibrium, Y = C + I + G = (25 + 0.75Y) + 100 + 150 = 275 + 0.75Y 0.25Y = 275 Y = 275 / 0.25 = 1100  The equilibrium level of output increases by 200 (from 900 to 1100).

9.2 Fiscal Policy at Work: Multiplier Effects (1) The Government Spending Multiplier When G = 50, Y increases by 200. How many times? Government spending multiplier = Y/ G = 200/50 = 4 times We will later demonstrate how to derive the formula for this multiplier.

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

9.2 Fiscal Policy at Work: Multiplier Effects (2) The Tax Multiplier Instead of increasing G, the government cuts taxes by 50 (T = -50). How much will equilibrium output Y increase? Using the same data as Table 9.1. I = 100, G = 100, but T = 50 (decreased by 50). C = 100 + 0.75Yd = 100 + 0.75(Y – 50) = 62.5 + 0.75Y At equilibrium, Y = C + I + G = (62.5 + 0.75Y) + 100 + 100 = 262.5 + 0.75Y 0.25Y = 262.5 Y = 262.5/ 0.25 = 1050  The equilibrium level of output increases by 150 (from 900 to 1050).

9.2 Fiscal Policy at Work: Multiplier Effects (2) The Tax Multiplier When T = -50, Y increases by 150. How many times? Tax multiplier = Y/ T = 150/-50 = -3 times We will later demonstrate how to derive the formula for this multiplier. Why is the tax multiplier smaller (-3) than the government spending multiplier (4)? When taxes are cut, it affects AE only through C by a fraction of T * MPC. For instance, when taxes are cut by 50, C only increases by 50 x 0.75 = 37.5.

9.2 Fiscal Policy at Work: Multiplier Effects (2) The Tax Multiplier For instance, When T = 100, C = 25 + 0.75Y When T = 50, C = 62.5 + 0.75Y Suggesting that after tax cut of 50, the consumption function, and hence AE function only moves up by 37.5 (compared with Figure 9.3, slide 15)

9.2 Fiscal Policy at Work: Multiplier Effects (3) The Balanced-Budget Multiplier What if now the government wants to increase output through G, but does not want to borrow to finance this spending. In this case, the increased spending has to be accompanied by increases in taxes, i.e. a balance budget (G = T). How much will equilibrium output Y increase? Using the same data as Table 9.1. I = 100, but G = 300 (increased by 200), and T = 300 (increased by 200) C = 100 + 0.75Yd = 100 + 0.75(Y – 300) = -125 + 0.75Y At equilibrium, Y = C + I + G = (-125 + 0.75Y) + 100 + 300 = 275 + 0.75Y 0.25Y = 275 Y = 275/ 0.25 = 1100

9.2 Fiscal Policy at Work: Multiplier Effects (3) The Balanced-Budget Multiplier The equilibrium level of output increases by 200 (from 900 to 1100). In other words, 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. We will later demonstrate how to derive this multiplier.

9.3 Deriving the multipliers when tax is fixed (lump sum) In a 3-sector economy, C = a + bYd where b is MPC At equilibrium,

9.3 Deriving the multipliers when tax is fixed (lump sum) Investment multiplier: Government spending multiplier: Tax multiplier: Balanced-budget multiplier: 22 of 35

9.3 Deriving the multipliers when tax is fixed (lump sum) Back to our example on slides 13-14. When the government increases spending by 50 (G = 50), how much will equilibrium output Y increase? Given that C = 100 + 0.75Yd, so MPC = 0.75 Government spending multiplier: So, when G increases by 50, Y will increase 4 times, i.e. 4 x 50 = 200

9.3 Deriving the multipliers when tax is fixed (lump sum) Back to our example on slides 16-17. When the government cuts taxes by 50 (T = -50), how much will equilibrium output Y increase? Given that C = 100 + 0.75Yd, so MPC = 0.75 Tax multiplier: So, when T decreases by 50, Y will increase 3 times, i.e. 3 x 50 = 150

9.3 Deriving the multipliers when tax is fixed (lump sum) Back to our example on slides 19-20. When the government increases spending by 200 (G = 200) and at the same raises taxes by 200 (T = 200), how much will equilibrium output Y increase? Given that C = 100 + 0.75Yd, so MPC = 0.75 Given that government spending multiplier is 4, Y = G x 4 times = 200 x 4 = 800 Given that tax multiplier is -3, Y = T x -3 times = 200 x -3 = -600 Net increase in Y = 800 – 600 = 200 (the same as G or T)

9.3 Deriving the multipliers when tax is fixed (lump sum) Question: Suppose that the economy is sitting at the equilibrium output Y of 900. Given the high employment rate, you are asked to present proposal for increasing the present output to 1100. Your options of fiscal policy include: Increase G only Cut T only Increase G but it must be matched by the same amount of increases in T (to maintain a balance budget) Assume that the MPC in the economy is 0.75. The answers are: (1) G = 50, (2) T = -66.67, (3) G = T = 200

9.4 Deriving the multipliers when tax depends on income Government sets tax rates, but tax revenues depend on taxable income, and income depends on the state of the economy. Suppose T = T0 + t Y where t is the tax rate In a 3-sector economy, C = a + bYd where b is MPC

9.4 Deriving the multipliers when tax depends on income At equilibrium,

9.4 Deriving the multipliers when tax depends on income Suppose T0 = -200 (transfer payments when income is zero) t = 1/3 Tax function: T = -200 + 1/3 Y (Assume G = 100, I = 100) No matter how taxes are calculated, MPC (out of disposable income) is still the same. In this case, MPC = 0.75 Consumption function: C = 100 + 0.75Y + 150 – 0.25Y C = 250 + 0.50Y

9.4 Deriving the multipliers when tax depends on income At equilibrium, Y = C + I + G = 250 + 0.50Y + 100 + 100 0.5Y = 450 Y = 450/0.5 = 900 Scenario 1, if G increases to 300 (G = 200), what is the new equilibrium Y? Answer: New Y = 1300 (Y = 1300 – 900 = 400), implying the spending multiplier is 2 (i.e. 400/200). Double check the multiplier using the derived formula, when MPC=0.75, and t=1/3. Do you get 2?

9.4 Deriving the multipliers when tax depends on income Scenario 2, if the government cuts lump-sum tax T0 to 600 ( T0 = -400), what is the new equilibrium Y? Answer: New Y = 1500 (Y = 1500 – 900 = 600), implying the tax multiplier is -1.5 (i.e. 600/-400). Hint: The new tax function is T = -600 + 1/3 Y Double check the multiplier using the derived formula, when MPC=0.75, and t=1/3. Do you get -1.5?

9.5 The Federal Budget federal budget The budget of the federal government. budget deficit/surplus The difference between what a government spends and what it collects in taxes in a given period. If G > T, budget deficit If G < T, budget surplus News The Malaysia 2010 budget can be downloaded from http://bajet.treasury.gov.my/index_bi.html

9.5 The Federal Budget U.S. Fiscal Policy Since 1993  FIGURE 9.4 Federal Personal Income Taxes as a Percentage of Taxable Income, 1993 I–2007 IV

9.5 The Federal Budget U.S. Fiscal Policy Since 1993  FIGURE 9.6 The Federal Government Surplus (+) or Deficit (–) as a Percentage of GDP, 1993 I–2007 IV

9.5 The Federal Budget U.S. Federal Government Debt  FIGURE 9.7 The Federal Government Debt as a Percentage of GDP, 1993 I–2007 IV