CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 1 of 63 PowerPoint Lectures for Principles of Macroeconomics, 9e By Karl E. Case, Ray C. Fair & Sharon M. Oster ; ;

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 2 of 63

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

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 4 of 63 9 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 III THE CORE OF MACROECONOMIC THEORY

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 5 of 63 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.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 6 of 63 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.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 7 of 63 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.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 8 of 63 Government in the Economy 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. Government Purchases (G), Net Taxes (T), and Disposable Income (Y d ) disposable income ≡ total income − net taxes Y d ≡ Y − T

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 9 of 63 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.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 10 of 63 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.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 11 of 63 Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d )  FIGURE 9.1 Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 12 of 63 Select the best answer. Households use their disposable income (Y d ) to do the following: a.Consume. b.Consume and save. c.Consume, save, and pay taxes. d.Consume, save, pay taxes, and buy imports.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 13 of 63 Select the best answer. Households use their disposable income (Y d ) to do the following: a.Consume. b.Consume and save. c.Consume, save, and pay taxes. d.Consume, save, pay taxes, and buy imports.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 14 of 63 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 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 15 of 63 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. budget deficit ≡ G − T

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 16 of 63 Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d ) 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 + bY d or C = a + b(Y − T) Our consumption function now has consumption depending on disposable income instead of before-tax income.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 17 of 63 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

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 18 of 63 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 + I + G c.C + I + G d.G – T

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 19 of 63 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 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 20 of 63 Government in the Economy 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 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 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 21 of 63 Government in the Economy The Determination of Equilibrium Output (Income)  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.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 22 of 63 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 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 23 of 63 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.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 24 of 63 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.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 25 of 63 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 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 26 of 63 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 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 27 of 63 Fiscal Policy at Work: Multiplier Effects The Government Spending Multiplier 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 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 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 28 of 63 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.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 29 of 63 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.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 30 of 63 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.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 31 of 63 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 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 32 of 63 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

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 33 of 63 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

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 34 of 63 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 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 35 of 63 Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier 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 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 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 36 of 63 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. c.Equilibrium income would decrease by $200, or double the amount of the increase in T. d.Nothing happens. Equilibrium income remains the same because the amount of government spending (G) is compensated by the amount of taxation (T).

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 37 of 63 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. c.Equilibrium income would decrease by $200, or double the amount of the increase in T. d.Nothing happens. Equilibrium income remains the same because the amount of government spending (G) is compensated by the amount of taxation (T).

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 38 of 63 Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier TABLE 9.4 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 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 39 of 63 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 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 40 of 63 The Federal Budget The Budget in 2007 TABLE 9.5 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 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 41 of 63 The Federal Budget The Budget in 2007 federal surplus (+) or deficit (  ) Federal government receipts minus expenditures.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 42 of 63 The Federal Budget Fiscal Policy Since 1993: The Clinton and Bush Administrations  FIGURE 9.4 Federal Personal Income Taxes as a Percentage of Taxable Income, 1993 I–2007 IV

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 43 of 63 The Federal Budget Fiscal Policy Since 1993: The Clinton and Bush Administrations  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–2007 IV

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 44 of 63 The Federal Budget Fiscal Policy Since 1993: The Clinton and Bush Administrations  FIGURE 9.6 The Federal Government Surplus (+) or Deficit (–) as a Percentage of GDP, 1993 I–2007 IV

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 45 of 63 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.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 46 of 63 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.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 47 of 63 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 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 48 of 63 The Federal Budget The Federal Government Debt  FIGURE 9.7 The Federal Government Debt as a Percentage of GDP, 1993 I–2007 IV

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 49 of 63 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 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 50 of 63 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.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 51 of 63 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.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 52 of 63 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 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 53 of 63 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 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 54 of 63 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.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 55 of 63 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. The government does not have complete control of either the revenue side or the expenditure side of the budget. 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.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 56 of 63 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 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 57 of 63 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.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 58 of 63 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.

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 59 of 63 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 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 60 of 63 DERIVING THE FISCAL POLICY MULTIPLIERS A P P E N D I X A THE GOVERNMENT SPENDING AND TAX MULTIPLIERS

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 61 of 63 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 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 62 of 63 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 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 63 of 63 THE CASE IN WHICH TAX REVENUES DEPEND ON INCOME A P P E N D I X B  FIGURE 9B.1 The Tax Function

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 64 of 63 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 9B.2 Different Tax Systems

CHAPTER 9 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 65 of 63 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