1. The Government and Fiscal Policy
Appendix A: Deriving the Fiscal Policy Multipliers
Appendix B: The Case in Which Tax Revenues Depend on Income
Prepared by: Fernando Quijano and Yvonn Quijano

2. Government in the Economy
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 the classical school) claim that fiscal and monetary policies are incapable of stabilizing the economy and, even worse, may be destabilizing and harmful. Most agree, however, that governments are important actors in the economy.

3. The government can affect the macroeconomy through fiscal policy (its spending and taxing behavior) and monetary policy (the behavior of the Federal Reserve regarding the nation’s money supply).
1. Fiscal policy includes changes in government purchases of goods and labor, taxes, and/or transfer payments to households with the objective of changing the economy’s growth.
2. Monetary policy means changes in the quantity of money in circulation with the objective of changing the economy’s growth. Often monetary policy is set as an interest rate target

4. Government in the Economy
We need to distinguish between variables that the government controls directly and those that are a consequence of government decisions.
1. For example, 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. For example, government spending for unemployment compensation increases when the economy moves into a recession and the unemployment rate rises.

5. Net Taxes (T), and Disposable Income (Yd)
Discretionary fiscal policy refers to any change in taxes or spending that is intended to influence the future path of the economy.
Net taxes are taxes paid by firms and households to the government minus transfer payments made to households by the government.* Disposable, or after-tax, income Yd equals total income minus taxes.

6. Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income

7. Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income
When government enters the picture, the aggregate income identity gets cut into three pieces:
And aggregate expenditure (AE) equals:

8. The Budget Deficit
A government’s budget deficit is the difference between what it spends (G) and what it collects in taxes (T) in a given period:
If G exceeds T, the government must borrow from the public to finance the deficit. It does so by selling Treasury bonds and bills. In this case, a part of household saving (S) goes to the government.

9. Adding Taxes to the Consumption Function
The aggregate consumption function is now a function of disposable, or after-tax, income.
What about investment? The government can affect investment behavior through its tax treatment of depreciation and other tax policies. Investment may also vary with economic conditions and interest rates, as we will see later. For our present purposes, we continue to assume that planned investment (I) is independent variable.

10. Equilibrium Output: Y = C + I + G
Finding Equilibrium for I = 100, G = 100, and T = 100 (All Figures in Billions of Dollars)
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
OUTPUT (INCOME) Y
NET TAXES T
DISPOSABLE INCOME Yd / Y - T
CONSUMPTION SPENDING (C = 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 DISEQUILIBRIUM
300
100
200
250
- 50
450
- 150
Output8
500
400
600
- 100
700
550 50
750
900
800
Equilibrium
1,100
1,000
850
150
1,050
+ 50
Output9
1,300
1,200
+ 100
1,500
1,400
1,150
1,350
+ 150

11. Finding Equilibrium Output/Income Graphically

12. The Leakages/Injections Approach
Taxes (T) are a leakage from the flow of income. Saving (S) is also a leakage.
In equilibrium, aggregate output (income) (Y) equals planned aggregate expenditure (AE), and leakages (S + T) must equal planned injections (I + G). Algebraically,

13. The Government Spending Multiplier
The Government Spending Multiplier is defined as the ratio of the change in the equilibrium level of output to a change in government spending. This is the same definition we used in the previous chapter, but now the independent variable is government spending instead of planned investment.

14. The Government Spending Multiplier
1. How can the government use taxing and spending policy to increase the equilibrium level of national output?
2. Increased government spending will lead to increased output, which leads to increased income. More workers are employed, and they in turn act as consumers and spend their incomes.
3. Output will rise again and so will income, etc. This is the multiplier in action. The government spending multiplier is the same as the investment multiplier.

15. The Government Spending Multiplier
Finding Equilibrium After a $50 Billion Government Spending Increase (All Figures in Billions of Dollars; G Has Increased From 100 in Table 25.1 to 150 Here)
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
OUTPUT (INCOME) Y
NET TAXES T
DISPOSABLE INCOME Yd / Y - T
CONSUMPTION SPENDING (C = 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 DISEQUILIBRIUM
300
100
200
250
- 50
150
500
- 200
Output8
400
650
- 150
700
600
550 50
800
- 100
900
950
1,100
1,000
850
Equilibrium
1,300
1,200
1,250
+ 50
Output9

16. The Government Spending Multiplier

17. The Tax Multiplier
The tax multiplier is the ratio of the change in equilibrium income to a change in taxes.
To reduce unemployment without increasing government spending, taxes must be cut. This increases disposable income, which is likely to add to consumption, which will lead to an increase in output and employment, and hence income, etc.

18. The Tax Multiplier
A tax cut increases disposable income, and leads to added consumption spending. Income will increase by a multiple of the decrease in taxes.
The multiplier for a change in taxes is smaller than the multiplier for a change in government spending.

19. Adding the International Sector
Opening the economy to foreign trade adds a fourth component to planned aggregate expenditure—exports of goods and services, or EX. Exports are foreign purchases of goods and services produced in the United States. Opening the economy to the rest of the world also means that U.S. consumers and businesses have greater choice because they can buy foreign-produced goods and services (imports, or IM) in addition to domestically produced goods and services.
We can think of imports (IM) as a leakage from the circular flow and exports (EX) as an injection into the circular flow. (Review Figure 5.1.) With imports and exports, the equilibrium condition for the economy is:
open-economy equilibrium: Y = C + I + G + (EX - IM)

20. The Balanced-Budget Multiplier
The balanced-budget multiplier is 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.

21. The Balanced-Budget Multiplier
Finding Equilibrium After a $200 Billion Balanced Budget Increase in G and T (All Figures in Billions of Dollars; G and T Have Increased From 100 in Table 25.1 to 300 Here)
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
OUTPUT (INCOME) Y
NET TAXES T
DISPOSABLE INCOME Yd / Y - T
CONSUMPTION SPENDING (C = Yd)
PLANNED INVESTMENT SPENDING I
GOVERNMENT PURCHASES G
PLANNED AGGREGATE EXPENDITURE C + I + G
UNPLANNED INVENTORY CHANGE Y - (C + I + G)
ADJUSTMENT TO DISEQUILIBRIUM
500
300
200
250
100
650
- 150
Output8
700
400
800
- 100
900
600
550
950
- 50
1,100
Equilibrium
1,300
1,000
850
1,250
+ 50
Output9
1,500
1,200
1,400
+ 100

22. Fiscal Policy Multipliers
Summary of Fiscal Policy Multipliers
POLICY STIMULUS
MULTIPLIER
FINAL IMPACT ON EQUILIBRIUM Y
Government- spending multiplier
Increase or decrease in the level of government purchases:
Tax multiplier
Increase or decrease in the level of net taxes:
Balanced-budget multiplier
Simultaneous balanced-budget increase or decrease in the level of government purchases and net taxes: 1

23. The Federal Budget
The federal budget is the budget of the federal government.
The difference between the federal government’s receipts and its expenditures is the federal surplus (+) or deficit (-).

24. The Federal Budget
Federal Government Receipts and Expenditures, 2000 (Billions of Dollars)
AMOUNT
PERCENTAGE OF TOTAL
Receipts
Personal taxes
1,010.1
49.6
Corporate taxes
193.2
9.5
Indirect business taxes
111.0
5.5
Contributions for social insurance
720.6
35.4
Total
2,034.9
100.0
Current Expenditures
Consumption
514.1
26.9
Transfer payments
831.9
43.6
Grants-in-aid to state and local governments
274.2
14.4
Net interest payments
236.9
12.4
Net subsidies of government enterprises
52.5
2.7
1,909.6
Current Surplus (+) or deficit (-) (Receipts - Current Expenditures)
Source: U.S. Department of Commerce, Bureau of Economic Analysis.

25. The Federal Government Surplus (+) or Deficit (-) as a Percentage of GDP, 1970 I-2003 II

26. The Debt
The federal debt is the total amount owed by the federal government. The debt is the sum of all accumulated deficits minus surpluses over time.
Some of the federal debt is held by the U.S. government itself and some by private individuals. The privately held federal debt is the private (non-government-owned) portion of the federal debt.

27. The Federal Government Debt as a Percentage of GDP, 1970 I-2003 II
The percentage began to fall in the mid 1990s.

28. The Economy’s Influence on the Government Budget
Automatic stabilizers are 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.

29. The Economy’s Influence on the Government Budget
Fiscal drag is the negative effect on the economy that occurs when average tax rates increase because taxpayers have moved into higher income brackets during an expansion.

30. The Economy’s Influence on the Government Budget
The full-employment budget is what the federal budget would be if the economy were producing at a full-employment level of output.

31. The Economy’s Influence on the Government Budget
The cyclical deficit is the deficit that occurs because of a downturn in the business cycle.
The structural deficit is the deficit that remains at full employment.

32. Review Terms and Concepts
automatic stabilizers
balanced-budget multiplier
budget deficit
cyclical deficit
discretionary fiscal policy
disposable, or after-tax, income
federal budget
federal debt
federal surplus (+) or deficit (-)
fiscal drag
fiscal policy
full-employment budget
government spending multiplier
monetary policy
net taxes
privately held federal debt
structural deficit
tax multiplier

33. Appendix A: Deriving the Fiscal Policy Multipliers
The government spending and tax multipliers algebraically:

34. Appendix A: Deriving the Fiscal Policy Multipliers
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
The balanced-budget multiplier equals one. An increase in G and T by one dollar each causes a one-dollar increase in Y.

35. Appendix B: The Case In Which Tax Revenues Depend on Income

36. Appendix B: The Case In Which Tax Revenues Depend on Income

37. Appendix B: The Case In Which Tax Revenues Depend on Income
The Government Spending and Tax Multipliers Algebraically:

38. Appendix B: The Case In Which Tax Revenues Depend on Income
The government spending and tax multipliers when taxes are a function of income are derived as follows: