CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 1 of 39 PowerPoint Lectures for Principles of Economics, 9e By Karl E. Case, Ray C. Fair & Sharon M. Oster ; ;

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 2 of 39

© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster PART V THE CORE OF MACROECONOMIC THEORY 24 The Government and Fiscal Policy Fernando & Yvonn Quijano Prepared by:

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 4 of Government in the EconomyGovernment Purchases ( G ), Net Taxes ( T ), and Disposable income ( Y d ) The Determination of Equilibrium Output (Income) Fiscal Policy at Work: Multiplier EffectsThe Government Spending MultiplierThe Tax MultiplierThe Balanced-Budget MultiplierThe Federal BudgetThe Budget in 2007Fiscal Policy Since 1993: The Clinton and Bush Administrations The Federal Government DebtThe 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 StabilizersFiscal DragFull-Employment BudgetLooking AheadAppendix A: Deriving the Fiscal Policy Multipliers Appendix B: The Case in Which Tax Revenues Depend on Income CHAPTER OUTLINE The Government and Fiscal Policy PART V THE CORE OF MACROECONOMIC THEORY

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 5 of 39 The multiplier applies to both external and internal variables that influence the economy. External changes include wars, the weather, and OPEC oil price changes. Some examples of internal variables that affect the economy via the multiplier are government spending, taxes, and investment.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 6 of 39 There is much controversy over the appropriate role government should play in the economy. This controversy constantly shifts between positive and normative arguments. 1.Keynesians believe that the macroeconomy is likely to fluctuate too much if left on its own 2.Others (known by various names but whose antecedents are the classical school) claim that fiscal and monetary policies are incapable of stabilizing the economy and, even worse, may be destabilizing and harmful. 3.Most agree, however, that governments are important actors in the economies of virtually all countries, like it or not.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 7 of 39 The Government and Fiscal Policy Fiscal Policy is any action that affects the government’s spending and taxing policies. Fiscal policy includes changes in government purchases of goods and services (mainly labor services), taxes, and/or transfer payments to households with the objective of changing the economy’s growth.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 8 of 39 Monetary policy is the behavior of the Federal Reserve concerning the nation ’ s money supply. Monetary policy is fundamentally changes in the quantity of money in circulation with the objective of changing the economy ’ s growth. Often monetary policy uses an interest rate target.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 9 of 39 We need to distinguish between variables that the government controls directly and those that are a consequence of government decisions. 1.For example, the government controls tax rates, but tax revenues are also affected by the state of the economy. 2.Similarly, government spending also depends both on government decisions and on the state of the economy. When the economy moves into a recession and unemployment rises, government spends more on unemployment compensation.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 10 of 39 Government in the Economy Net taxes (T) is taxes paid by firms and households to the government minus transfer payments made to households by the government. Net taxes equals tax revenue less transfer payments. disposable, or after-tax, income (Y d ) Total income minus net taxes: Y - T. Government Purchases (G), Net Taxes (T), and Disposable Income (Y d ) disposable income ≡ total income − net taxes Y d ≡ Y − T

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 11 of 39 The government finances its expenditures by taxing (and borrowing). When a fixed sum of money is collected by the government as taxes, regardless of the level of output in the economy. In this case, DI is no longer equal to GDP. However, the relationship between the two terms is very direct: DI + T = GDP

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 12 of 39 Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d )  FIGURE 24.1 Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 13 of 39 Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d ) When government enters the picture, the aggregate income identity gets cut into three pieces: And aggregate expenditure (AE) equals:

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 14 of 39 Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d ) budget deficit The difference between what a government spends and what it collects in taxes in a given period: G - T. In 2008, the United States, Japan, the United Kingdom, France, and Italy had budget deficits. Canada had a small budget surplus. As a fraction of GDP, the U.S. deficit was about 4 percent and Japan’s deficit was about 3 percent.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 15 of 39 Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d ) Adding Taxes to the Consumption Function 1-Consumption spending now depends on disposable personal income rather than on personal (before-tax) income: C = a + bY d. 2-The slope of the consumption function depends on both the MPC and the tax rate. C = a + bY d or C = a + b(Y − T) Our consumption function now has consumption depending on disposable income instead of before-tax income.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 16 of 39 Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d ) Planned Investment The government can affect investment behavior through its tax treatment of depreciation and other tax policies.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 17 of 39 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 Y d / Y  T Consumption Spending (C = Y d ) Saving S (Y d – 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   150 Output  100 Output  50 Output Equilibrium 1, , , Output9 1, ,2001, , Output9 1, ,4001, , Output9

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 18 of 39 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.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 19 of 39 A change in G means the total spending line will shift up or down. Total expenditure in the economy now equals C + I + G. (The only remaining term to be added is net exports.) If total expenditure in the economy exceeds the level of output, the economy will expand. Alternatively, if C + I + G is less than the level of output, the economy will contract.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 20 of 39 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

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 21 of 39 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

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Government spending multiplier What happens if Gov’t decides to increase its level of expenditure in light of the output gap ( rising unemployment )? Similar to increase in an autonomous investment expenditure, the Gov’t expenditure will also cause multiplier effects in the economy and will increase national output and employment. 22 of 39

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster What we mean by Gov’t EX There are tow principle measurements of Gov’t in the economy, Gov’t Ex on current goods and services ( the G in national income account) & the total EX, which equal G + Transfers. These transfers do not enter the national income identity because they do not represents EX on goods & services produced in the circular flow of income- they can be thought of as negative taxes and income in the form of transfers to the old, unemployed….. Figure of 39

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 24 of 39 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.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 25 of 39 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 Y d / Y  T Consumption Spending (C = Y d ) Saving S (Y d – C) Planned Investment Spending I Government Purchases G Planned Aggregate Expenditure C + I + G Unplanned Inventory Change Y  (C + I + G) Adjustment To Disequilibrium   200 Output  150 Output  100 Output  50 Output8 1, , ,1000Equilibrium 1, ,2001, , Output 

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 26 of 39 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.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 27 of 39 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.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 28 of 39 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.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 29 of 39 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 Y d / Y  T Consumption Spending (C = Y d ) Planned Investment Spending I Government Purchases G Planned Aggregate Expenditure C + I + G Unplanned Inventory Change Y  (C + I + G) Adjustment To Disequilibrium  150 Output  100 Output  50 Output8 1, ,1000Equilibrium 1, , , Output9 1, ,2001, , Output9

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 30 of 39 Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier TABLE 24.4 Summary of Fiscal Policy Multipliers Policy StimulusMultiplier Final Impact On Equilibrium Y Government spending multiplier Increase or decrease in the level of government purchases: ∆G Tax multiplierIncrease 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

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Foreign Trade Multiplier In closed economy equity between leakages S+T & injections I+G is a must for equilibrium. On an open economy, there are tow important variables to be considered, exports X & imports M, Equilibrium in an open economy S+T+M = I+G+X Exports like investment, they represent spending on domestic goods & services by foreigners & so are a source of income for domestic factors of income. 31 of 39

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Exports have a multiplier effect like investment, when factors income increase, there will be two possible leakages. A from the new income goes for MPS, imports may also rise, both are leakages from injected exports. Hence the foreign trade multiplier( also called the export multiplier) Can be represented as kf=1/(s+m) Kf= export multiplier S= MPS M= MPI If MPS =0.2 & MPI = 0.2 then kf=1/( ) = 1/0.4= of 39

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster How large the expansionary effect on national income will be from a given increase in exports depends on the slope of the savings-imports schedule. This slope, obviously, depends on the MPS & MPI. 33 of 39

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 34 of 25 The Role of Fiscal Policy Government policies that increase aggregate demand are called expansionary policies. Government policies that decrease aggregate demand are called contractionary policies.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 35 of 25 The Limits to Stabilization Policies Both expansionary policies and contractionary policies are examples of stabilization polices, actions to move the economy closer to full employment or potential output. Stabilization policy is difficult because there are time lags between recognition and response to changes in the economy, and because we simply do not know enough about all aspects of the economy.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 36 of 25 The Federal Budget The federal budget—the actual document that describes what the federal government spends and how it pays for it—provides the framework for fiscal policy. In 2003, total federal spending approximately was 19.9 percent of GDP, or $2.15 trillion. Federal taxes were 16.5 percent of GDP. The government runs its budget on a fiscal year basis, from October 1 to September 30.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 37 of 25 Federal Spending Table 10.1 Federal Spending for Fiscal Year 2003 CategoryOutlays (billions) Percent of GDP Total outlays$2, % Discretionary spending Defense Non-Defense Entitlements and mandatory spending1, Social Security Medicare and Medicaid Other programs Net interest1531.4

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 38 of 25 Federal Spending Discretionary spending constitutes all the programs that Congress authorizes on an annual basis, which are not automatically funded by prior laws passed by Congress. Entitlements and mandatory spending constitutes all spending that Congress authorized by prior laws. They are the single largest component of the federal budget.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 39 of 25 Federal Spending Social security provides retirement payments to retirees, as well as a host of other benefits to widows and families of disabled workers. Medicare provides health care to all individuals once they reach the age of 65. Medicaid provides health care to the poor, in conjunction with the states. Some of these programs are means-tested. That is, they are partly based on the income of the recipient.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 40 of 25 Federal Revenues Table 10.2 Sources of Federal Government Revenue, Fiscal Year 2003 CategoryReceipts (billions) Percent of GDP Total revenue$1, % Individual income taxes Social insurance taxes Estate and gift taxes Corporate income taxes Excise taxes and customs duties Miscellaneous receipts 340.3

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 41 of 25 Automatic Stabilizers Taxes and transfer payments that stabilize GDP without requiring explicit actions by policymakers are called automatic stabilizers. During an economic boom, transfer payments fall and taxes increase. During a recession, running a government budget deficit offsets part of the adverse effect of the recession and thus helps stabilize the economy.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 42 of 25 Concerns About Deficits In the long run, large budget deficits can have an adverse effect on the economy. When the economy is at full employment, a cut in household taxes will tend to increase consumer spending. However, since output is fixed at full employment, some other component of output must be reduced, or crowed out. This is an example of the principle of opportunity cost. PRINCIPLE of Opportunity Cost The opportunity cost of something is what you sacrifice to get it.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 43 of 39 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.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 44 of 39 The Federal Budget The Budget in 2007 TABLE 24.5 Federal Government Receipts and Expenditures, 2007 (Billions of Dollars) AmountPercentage Of Total Receipts Personal income taxes1, Excise taxes and customs duties Corporate income taxes Taxes from the rest of the world Contributions for social insurance Interest receipts and rents and royalties Current transfer receipts from business and persons Current surplus of government enterprises − 2.3 − 0.0 Total2, Current Expenditures Consumption expenditures Transfer payments to persons1, Transfer payments to the rest of the world Grants-in-aid to state and local governments Interest payments Subsidies Total2, Net federal government saving—surplus (+) or deficit (−) (Total current receipts − Total current expenditures) − Source: U.S. Department of Commerce, Bureau of Economic Analysis.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 45 of 39 The Federal Budget The Budget in 2007 federal surplus (+) or deficit (  ) Federal government receipts minus expenditures.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 46 of 39 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

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 47 of 39 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

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 48 of 39 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

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 49 of 39 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.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 50 of 39 The Federal Budget The Federal Government Debt  FIGURE 24.7 The Federal Government Debt as a Percentage of GDP, 1993 I–2007 IV

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 51 of 39 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.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 52 of 39 The Economy’s Influence on the Government Budget Some Government Expenditures Depend on the State of the Economy Fiscal Policy In 2008 Congress Approves Economic-Stimulus Bill Wall Street Journal

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 53 of 39 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.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 54 of 39 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.

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 55 of 39 automatic stabilizers balanced-budget multiplier budget deficit cyclical deficit discretionary fiscal policy disposable, or after-tax, income (Y d ) federal budget federal debt federal surplus (+) or deficit (−) fiscal drag fiscal policy full-employment budget government spending multiplier monetary policy REVIEW TERMS AND CONCEPTS net taxes (T) privately held federal debt structural deficit tax multiplier 1.Disposable income Y d ≡ 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

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 56 of 39 DERIVING THE FISCAL POLICY MULTIPLIERS A P P E N D I X A THE GOVERNMENT SPENDING AND TAX MULTIPLIERS

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 57 of 39 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

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 58 of 39 DERIVING THE FISCAL POLICY MULTIPLIERS THE BALANCED-BUDGET MULTIPLIER A P P E N D I X A 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:

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 59 of 39 THE CASE IN WHICH TAX REVENUES DEPEND ON INCOME A P P E N D I X B  FIGURE 24B.1 The Tax Function

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 60 of 39 THE CASE IN WHICH TAX REVENUES DEPEND ON INCOME A P P E N D I X B 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.  FIGURE 24B.2 Different Tax Systems

CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 61 of 39 THE CASE IN WHICH TAX REVENUES DEPEND ON INCOME A P P E N D I X B THE GOVERNMENT SPENDING AND TAX MULTIPLIERS ALGEBRAICALLY