1 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education CHAPTER OUTLINE 24 The Government and Fiscal Policy Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d ) 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 2009 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

2 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education fiscal policy The government’s spending and taxing policies. monetary policy The behavior of the Central Bank concerning the nation’s money supply.

3 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education discretionary fiscal policy Changes in taxes or spending that are the result of deliberate changes in government policy. 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 (Y d ) Total income minus net taxes: Y − T. disposable income ≡ total income − net taxes Y d ≡ Y − T Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d )

4 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education  FIGURE 24.1 Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d )

5 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education The disposable income (Y d ) of households must end up as either consumption (C) or saving (S). Thus, Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d ) 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).

6 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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 (Y d )

7 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education To modify our aggregate consumption function to incorporate disposable income instead of before-tax income, instead of C = a + bY, we write 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. Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d ) Adding Taxes to the Consumption Function

8 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education The government can affect investment behavior through its tax treatment of depreciation and other tax policies. Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d ) Planned Investment

9 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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, , , Output ↓ 1, ,2001, , Output ↓ 1, ,4001, , Output ↓ Government in the Economy The Determination of Equilibrium Output (Income)

10 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education  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. Government in the Economy The Determination of Equilibrium Output (Income)

11 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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 Government in the Economy The Determination of Equilibrium Output (Income) The Saving/Investment Approach to Equilibrium

12 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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

13 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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

14 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education TABLE 24.2 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 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 Output ↑ 1, , ,1000Equilibrium 1, ,2001, , Output ↓ Fiscal Policy at Work: Multiplier Effects The Government Spending Multiplier

15 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education  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 Government Spending Multiplier

16 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education tax multiplier The ratio of change in the equilibrium level of output to a change in taxes. Fiscal Policy at Work: Multiplier Effects The Tax Multiplier 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:

17 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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

18 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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 9.1 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 Output ↑ 1, ,1000Equilibrium 1, , , Output ↓ 1, ,2001, , Output ↓ Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier

19 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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 Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier

20 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier 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.

21 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education federal budget The budget of the federal government. The “budget” is really three different budgets: It is a political document that dispenses favors to certain groups or regions and places burdens on others. It is a reflection of goals the government wants to achieve. The budget may be an embodiment of some beliefs about how (if at all) the government should manage the macroeconomy. The Federal Budget

22 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education federal surplus (+) or deficit (−) Federal government receipts minus expenditures. The Federal Budget The Budget in 2009

23 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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

24 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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 The negative effect on the economy that occurs when average tax rates increase because taxpayers have moved into higher income brackets during an expansion. The Economy’s Influence on the Government Budget Automatic Stabilizers and Destabilizers 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.

25 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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. The Economy’s Influence on the Government Budget Full-Employment Budget

26 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education automatic destabilizers 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 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 a government: Y = C + I + G 5.Saving/investment approach to equilibrium in an economy with a government: S + T = I + G 6.Government spending multiplier ≡ 7.Tax multiplier ≡ 8.Balanced-budget multiplier ≡ 1 R E V I E W T E R M S A N D C O N C E P T S

27 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education CHAPTER 24 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):

28 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education It is easy to show formally that the balanced-budget multiplier = 1. increase in spending: − decrease in spending: = net increase in spending In a balanced-budget increase,  G =  T; so we can substitute: net initial increase in spending:  G −  G (MPC) =  G (1 − MPC) CHAPTER 24 APPENDIX A Deriving the Fiscal Policy Multipliers The Balanced-Budget Multiplier

29 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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: CHAPTER 24 APPENDIX A Deriving the Fiscal Policy Multipliers The Balanced-Budget Multiplier Thus, the final total increase in the equilibrium level of Y is just equal to the initial balanced increase in G and T.

30 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education  FIGURE 24B.1 The Tax Function CHAPTER 24 APPENDIX B The Case in Which Tax Revenues Depend on Income This graph shows net taxes (taxes minus transfer payments) as a function of aggregate income.

31 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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 APPENDIX B The Case in Which Tax Revenues Depend on Income

32 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education CHAPTER 24 APPENDIX B The Government Spending and Tax Multipliers Algebraically The Case in Which Tax Revenues Depend on Incomes Through substitution we get Solving for Y:

33 of 42 PART V The Core of Macroeconomic Theory © 2012 Pearson Education CHAPTER 24 APPENDIX B The Government Spending and Tax Multipliers Algebraically The Case in Which Tax Revenues Depend on Incomes This means that a $1 increase in G or I (holding a and T 0 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 T 0 ) will increase the equilibrium level of income by