Chapter Twenty Five The Government and Fiscal Policy

Government in the Economy 4 Fiscal Authority: Congress and the President and state and local officials 4 Responsibilities: –Set purchasing levels (G) –Set taxes (T) 4 We’ll assume that G and T are set at constant levels.

Disposable Income 4 Net Taxes: taxes minus transfers 4 Disposable income: income minus taxes Y d = Y - T

Aggregate Expenditures - with Government - AE = C + I + G Y d = Y - T Y d = C + S Y - T = C + S Y = C + S + T

The Model Economy 4 C = *(Income - Taxes) = *Y d 4 I = 50 4 G = 100 and T = 60.

Equilibrium 4 C + I + G = AE – *Income d = AE – *Income d = AE 4 AE = Income – *Income d = Income – *(Income - 60) = Income –605= ( )*Income –2420 = Income

Equilibrium 4 Income = 2420 – C = *( ) = 2270 – S = Taxes - C = 90 4 C + I + G = = 2420 = Y 4 S + Taxes = 150 = = G + I

Equilibrium 4 Income = 2420 – C = *( ) = 2270 – S = Taxes - C = 90 4 C + I + G = = 2420 = Y 4 S + Taxes = 150 = = G + I Note that S + T = G + I

Consumption= Y d Aggregate Planned Expenditures Income Savings + Taxes Investment=$50 C C+I C+I+G Government= o

Income 500 C C+I+G = AE 650 Y=2240 GDP Aggregate Planned Expenditures 45 o

Income C C+I C+I+G 650 Consumption Savings + Taxes 2240 Aggregate Planned Expenditures 45 o

Income C C+I C+I+G 650 Consumption G + I 2240 Aggregate Planned Expenditures 45 o

AE = C + I + G Income (Y)2950 C = *Y G=50, T=0 I=40 Expenditures 45 o

C + I + G 1 Income (Y)2950 C = *Y G=60, T=0 I=40 Expenditures Suppose G increases by 10, taxes increase by C + I + G 2 Y increases by o

The Government Spending Multiplier   G = 10 and  Y = 50 4 Multiplier = 50/10 = 5 4 Multiplier = 1/(1-MPC) = 5

AE 2 = C + I + G Income (Y)2950 C = *Y G=50, T=10 I=40 Expenditures Suppose T increases by AE 1 = C + I + G Y decreases by 40

The Tax Multiplier   T = 10 and  Y = Multiplier = -40/10 = -4 4 Multiplier = MPC/(1-MPC) = -4

AE 2 = C + I + G Income (Y)2950 C = *Y G=60, T=10 I=40 Expenditures Suppose G increases by 10, T increases by AE 1 = C + I + G increases Y increases by o

Balanced Budget Multiplier   G = 10 and  Y = Multiplier = 10/10 = 1

Multipliers == 1 1-MPC 1 1 Government spending multiplier Government spending multiplier Investment spending multiplier Investment spending multiplier Consumption spending multiplier Consumption spending multiplier ==

Multipliers 1 > MPC 1-MPC > 1 Government spending multiplier Government spending multiplier Tax decrease multiplier Tax decrease multiplier Balanced budget multiplier Balanced budget multiplier >>

The Federal Budget, Deficit, and Debt 4 Deficit 4 Deficit = G - Taxes –cyclical deficit –cyclical deficit: part of deficit which is due to the business cycle –structural deficit –structural deficit: part of deficit which exists even at full employment

Receipts and Outlays Federal Receipts and Outlays, (Billions of Current Dollars) Years Billions of Dollars Source: "Economic Report of the President, 1995", Table B-74, p Receipts Outlays

Federal Deficit Federal Surplus or Deficit, (Billions of Current Dollars) Years Billions of Dollars Source: "Economic Report of the President, 1995", Table B-74, p

Measuring the Deficit 4 Deficit = Expenditures - Taxes 4 As a percentage of GDP

Deficit as a Percentage of GDP

National Debt national debt The national debt refers to the total accumulation of past deficits.

The Economy’s Influence on the Deficit 4 Fiscal drag 4 Tax revenues that depend on the economy 4 Expenditures that depend on the economy 4 Automatic stabilizers

Government Deficits and Debt as a Percentage of nominal GDP, 1997, for selected countries

Review Terms & Concepts 4 Automatic stabilizers 4 Balanced budget multiplier 4 Budget deficit 4 Cyclical deficit 4 Discretionary fiscal policy 4 Disposable (after-tax) income 4 Federal budget 4 Federal debt 4 Federal deficit 4 Fiscal drag 4 Fiscal policy 4 Full-employment budget 4 Government spending multiplier

Review Terms & Concepts (cont.) 4 Monetary policy 4 Net exports 4 Net taxes 4 Privately held federal debt 4 Structural deficit 4 Tax multiplier