1. © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair Prepared by: Fernando & Yvonn Quijano 9 Chapter The Government and Fiscal Policy

2. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 64 Chapter Outline 9 The Government and Fiscal Policy Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable income (Y d ) Equilibrium Output: Y = C + I + G Fiscal Policy at Work: Multiplier Effects The Government Spending Multiplier The Tax Multiplier The Balanced-Budget Multiplier The Federal Budget The Budget The Surplus or Deficit The Debt 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 Fiscal Drag Full-Employment Budget Looking Ahead Appendix A: Deriving the Fiscal Policy Multipliers Appendix B: The Case in Which Tax Revenues Depend on Income

3. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 3 of 64 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.

4. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 4 of 64 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.

5. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 5 of 64 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.

6. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 6 of 64 GOVERNMENT IN THE ECONOMY discretionary fiscal policy Changes in taxes or spending that are the result of deliberate changes in government policy.

7. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 7 of 64 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.

8. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 8 of 64 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.

9. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 9 of 64 GOVERNMENT IN THE ECONOMY GOVERNMENT PURCHASES (G), NET TAXES (T), AND DISPOSABLE INCOME (Y D ) net taxes (T) Taxes paid by firms and households to the government minus transfer payments made to households by the government.

10. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 10 of 64 GOVERNMENT IN THE ECONOMY FIGURE 9.1Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income

11. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 11 of 64 GOVERNMENT IN THE ECONOMY disposable, or after-tax, income (Y d ) Total income minus net taxes: Y − T. disposable income ≡ total income − net taxes Y d ≡ Y − T

12. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 12 of 64 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.

13. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 13 of 64 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.

14. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 14 of 64 GOVERNMENT IN THE ECONOMY When government enters the picture, the aggregate income identity gets cut into three pieces: And aggregate expenditure (AE) equals:

15. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 15 of 64 GOVERNMENT IN THE ECONOMY 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

16. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 16 of 64 GOVERNMENT IN THE ECONOMY 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.

17. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 17 of 64 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

18. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 18 of 64 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

19. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 19 of 64 GOVERNMENT IN THE ECONOMY Investment The government can affect investment behavior through its tax treatment of depreciation and other tax policies.

20. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 20 of 64 GOVERNMENT IN THE ECONOMY EQUILIBRIUM OUTPUT: Y = C + I + G equilibrium condition: Y = C + I + G TABLE 9.1 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 Y d / Y  T CONSUMPTION SPENDING (C = 100 +.75 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 300100200250  50 100 450  150 Output 8 500100400 0100 600  100 Output 8 70010060055050100 750  50 Output 8 900100800700100 9000Equilibrium 1,1001001,000850150100 1,050+ 50 Output 9 1,3001001,2001,000200100 1,200+ 100 Output 9 1,5001001,4001,150250100 1,350+ 150 Output 9

21. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 21 of 64 GOVERNMENT IN THE ECONOMY FIGURE 9.2Finding Equilibrium Output/Income Graphically

22. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 22 of 64 GOVERNMENT IN THE ECONOMY The Leakages/Injections Approach to Equilibrium leakages/injections approach to equilibrium: S + T = I + G 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,

23. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 23 of 64 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.

24. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 24 of 64 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.

25. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 25 of 64 FISCAL POLICY AT WORK: MULTIPLIER EFFECTS THE GOVERNMENT SPENDING MULTIPLIER TABLE 9.2 Finding Equilibrium After a $50 Billion Government Spending Increase (All Figures in Billions of Dollars; 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 = 100 +.75 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 300100200250  50 100150500  200 Output 8 500100400 0100150650  150 Output 8 70010060055050100150800  100 Output 8 900100800700100 150950  50 Output 8 1,1001001,0008501501001501,1000Equilibrium 1,3001001,2001,0002001001501,250+ 50 Output 9

26. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 26 of 64 FISCAL POLICY AT WORK: MULTIPLIER EFFECTS government spending multiplier The ratio of the change in the equilibrium level of output to a change in government spending.

27. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 27 of 64 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.

28. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 28 of 64 How much of an increase in government spending would be required to generate a $200 billion increase in the equilibrium level of output? An amount less than $200 billion in government spending. 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.

29. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 29 of 64 FISCAL POLICY AT WORK: MULTIPLIER EFFECTS FIGURE 9.3The Government Spending Multiplier

30. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 30 of 64 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. The multiplier for a change in taxes is not the same as the multiplier for a change in government spending.

31. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 31 of 64 FISCAL POLICY AT WORK: MULTIPLIER EFFECTS

32. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 32 of 64 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

33. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 33 of 64 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

34. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 34 of 64 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 is exactly the same size as the initial change in G or T itself.

35. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 35 of 64 FISCAL POLICY AT WORK: MULTIPLIER EFFECTS An increase in government spending has a direct initial effect on planned aggregate expenditure; a tax increase does not. The initial effect of the tax increase is that households cut consumption by the MPC times the change in taxes. This change in consumption is less than the change in taxes, because the MPC is less than 1. The positive stimulus from the government spending increase is thus greater than the negative stimulus from the tax increase. The net effect is that the balanced-budget multiplier is 1.

36. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 36 of 64 FISCAL POLICY AT WORK: MULTIPLIER EFFECTS TABLE 9.3 Finding Equilibrium After a $200-Billion Balanced-Budget Increase in G and T (All Figures in Billions of Dollars; 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 = 100 +.75 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 500300200250100300650  150 Output 8 700300400 100300800  100 Output 8 900300600550100300950  50 Output 8 1,1003008007001003001,1000Equilibrium 1,3003001,0008501003001,250+ 50 Output 9 1,5003001,2001,0001003001,400+ 100 Output 9

37. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 37 of 64 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).

38. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 38 of 64 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).

39. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 39 of 64 FISCAL POLICY AT WORK: MULTIPLIER EFFECTS 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: Tax multiplierIncrease 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

40. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 40 of 64 THE FEDERAL BUDGET federal budget The budget of the federal government.

41. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 41 of 64 THE FEDERAL BUDGET THE BUDGET TABLE 9.5 Federal Government Receipts and Expenditures, 2004 (Billions of Dollars) AMOUNT PERCENTAGE OF TOTAL Receipts Personal income taxes801.840.6 Excise taxes and custom duties94.04.8 Corporate income taxes217.411.0 Taxes from the rest of the world9.20.5 Contributions for social insurance802.540.6 Interest receipts and rents and royalties21.9 1.1 Current transfer receipts from business and persons28.61.4 Current surplus of government enterprises − 0.5 0.0 Total1,974.8100.0 Current Expenditures Consumption expenditures725.730.5 Transfer payments to persons1,014.042.6 Transfer payments to the rest of the world28.91.2 Grants-in-aid to state and local governments348.314.6 Interest payments221.59.3 Subsidies 43.0 1.8 Total2,381.3100.0 Net federal government saving—surplus (+) or deficit (−) (total current receipts − total current expenditures) − 406.5 Source: U.S. Department of Commerce, Bureau of Economic Analysis.

42. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 42 of 64 THE FEDERAL BUDGET THE SURPLUS OR DEFICIT federal surplus (+) or deficit (−) Federal government receipts minus expenditures. FIGURE 9.4The Federal Government Surplus (+) or Deficit (−) as a Percentage of GDP, 1970 I–2005 II

43. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 43 of 64 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.

44. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 44 of 64 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.

45. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 45 of 64 THE FEDERAL BUDGET THE DEBT federal debt The total amount owed by the federal government. privately held federal debt The privately held (nongovernment- owned) debt of the U.S. government.

46. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 46 of 64 THE FEDERAL BUDGET FIGURE 9.5The Federal Government Debt as a Percentage of GDP, 1970 I–2005 II

47. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 47 of 64 THE ECONOMY’S INFLUENCE ON THE GOVERNMENT BUDGET TAX REVENUES DEPEND ON THE STATE OF THE ECONOMY Tax revenue depends on taxable income, and income depends on the state of the economy, which the government does not control.

48. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 48 of 64 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.

49. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 49 of 64 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.

50. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 50 of 64 THE ECONOMY’S INFLUENCE ON THE GOVERNMENT BUDGET 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.

51. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 51 of 64 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.

52. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 52 of 64 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.

53. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 53 of 64 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.

54. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 54 of 64 THE ECONOMY’S INFLUENCE ON THE GOVERNMENT BUDGET 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.

55. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 55 of 64 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 a 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.

56. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 56 of 64 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.

57. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 57 of 64 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.

58. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 58 of 64 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 Yd ≡ 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.Leakages/injections approach to equilibrium in an economy with government: S + T = I + G 6.Government spending multiplier ≡ 7.Tax multiplier ≡ 8.Balanced-budget multiplier ≡ 1

59. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 59 of 64 DERIVING THE FISCAL POLICY MULTIPLIERS Appendix A THE GOVERNMENT SPENDING AND TAX MULTIPLIERS

60. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 60 of 64 Appendix A 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)

61. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 61 of 64 Appendix 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:

62. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 62 of 64 THE CASE IN WHICH TAX REVENUES DEPEND ON INCOME Appendix B FIGURE 9B.1The Tax Function

63. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 63 of 64 Appendix B FIGURE 9B.2Different Tax Systems

64. CHAPTER 9: The Government and Fiscal Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 64 of 64 Appendix B THE GOVERNMENT SPENDING AND TAX MULTIPLIERS ALGEBRAICALLY