1. THE GOVERNMENT AND FISCAL POLICY
TOPIC 6
THE GOVERNMENT AND FISCAL POLICY

2. Government in the Economy
Government can affect the macro economy in two ways:
Fiscal policy is the manipulation of government spending and taxation.
Monetary policy refers to the behavior of the Federal Reserve regarding the nation’s money supply.

3. Net Taxes (T), and Disposable Income (Yd)
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.

4. 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:
Yd = Y – T
Yd = C + S
Y – T = C + S
Y = C + S + T
And aggregate expenditure (AE) equals:
AE = C + I + G

5. Adding Taxes to the Consumption Function
C = a + bYd
Yd = Y – T
C = a + b ( Y – T )
The aggregate consumption function is now a function of disposable, or after-tax, income.

6. Equilibrium Output: Y = C + I + G
C = Yd C = ( Y – T )
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 AGGRE-GATE EXPENDI-TURE C + I + G
UNPLANNED INVENTORY CHANGE Y - (C + I
+ G)
ADJUSTMENT TO DISEQUILIBRIUM
300
100
200
250
- 50
450
- 150
Output
500
400
600
- 100
700
550 50
750
900
800
Equilibrium
1,100
1,000
850
150
1,050
+ 50
1,300
1,200
+ 100
1,500
1,400
1,150
1,350
+ 150

7. Finding Equilibrium Output/Income Graphically

8. 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,
AE = C + I + G
Y = C + S + T
C + S + T = C + I + G
S + T = I + G

9. The Government Spending Multiplier
The government spending multiplier is the ratio of the change in the equilibrium level of output to a change in government spending. 1
spending
Government
multiplier =
MPS

10. 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.
A tax cut has no direct impact on spending. The multiplier for a change in taxes is smaller than the multiplier for a change in government spending.

11. The Tax Multiplier

12. 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.