1. Government in the Economy
Nothing arouses as much controversy as the role of government in the economy.
Government can affect the macroeconomy through two policy channels: fiscal policy and monetary policy.
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.

2. Government in the Economy
Tax rates are controlled by the government, but tax revenue depends on changes in household income and the size of corporate profits, which the government cannot control.
Discretionary fiscal policy refers to changes in taxes or spending that are the result of deliberate changes in government policy.

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

5. 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:

6. 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.

7. Adding Taxes to the Consumption Function
With taxes a part of the picture, the aggregate consumption function is a function of disposable, or after-tax, income.

8. 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
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

9. Finding Equilibrium Output/Income Graphically

10. 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,

11. 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.

12. 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

13. The Government Spending Multiplier

14. The Tax Multiplier
A tax cut increases disposable income, which is likely to lead to added consumption spending. Income will increase by a multiple of the decrease in taxes.
However, a tax cut has no direct impact on spending. The tax multiplier for a change in taxes is smaller than the multiplier for a change in government spending.

15. The Tax Multiplier
However, a tax cut has no direct impact on spending. The tax multiplier for a change in taxes is smaller than the multiplier for a change in government spending.

16. 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.

17. 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

18. 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

19. Adding the International Sector
We can think of imports (IM) as a leakage from the circular flow and exports (EX) as an injection into the circular flow.
With imports and exports, the equilibrium condition for the economy is:
The quantity (EX – IM) is referred to as net exports. Increases or decreases in net exports can throw the economy out of equilibrium and cause national income to change.

20. The Federal Budget
Federal Government Receipts and Expenditures, 2000 (Billions of Dollars)
AMOUNT
PERCENTAGE OF TOTAL
Receipts
Personal taxes
774.4
44.9
Corporate taxes
211.9
12.3
Indirect business taxes
91.3
5.3
Contributions for social insurance
645.9
37.5
Total
1,723.4
100.0
Current Expenditures
Consumption
463.8
26.5
Transfer payments
795.5
45.4
Grants-in-aid to state and local governments
224.2
12.8
Net interest payments
230.3
13.1
Net subsidies of government enterprises
38.4
2.2
1,752.2
Current Surplus (+) or deficit (-) (Receipts - Current Expenditures)
- 28.8
Source: U.S. Department of Commerce, Bureau of Economic Analysis.

21. The Federal Government Surplus/Deficit as a Percentage of GDP, 1970 I-2000 IV

22. The Federal Government Debt as a Percentage of GDP, 1970 I-2000 IV
The percentage began to fall in the mid 1990s.

23. The 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 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.

24. 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.

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

26. 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.

27. Appendix A: The government spending and tax multipliers
The government spending and tax multipliers when taxes are a function of income are derived as follows:
multiplier
value of autonomous expenditures

28. Appendix A: The Balanced-Budget Multiplier
If we combine the effects of the government spending multiplier and the tax multiplier, we obtain:
Multiplier of government spending
Tax multiplier
and
then:
In words, a simultaneous increase in government spending by $1 and lump-sum taxes by $1 will increase equilibrium income by $1.

29. Appendix B: The government spending and tax multipliers
The government spending and tax multipliers are derived algebraically as follows:
multiplier
value of autonomous expenditures