1. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 1 of 39 PowerPoint Lectures for Principles of Economics, 9e By Karl E. Case, Ray C. Fair & Sharon M. Oster ; ;

2. © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster PART V THE CORE OF MACROECONOMIC THEORY 24 The Government and Fiscal Policy Fernando & Yvonn Quijano Prepared by:

3. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 3 of 39 24 Government in the EconomyGovernment Purchases ( G ), Net Taxes ( T ), and Disposable income ( Y d ) The Determination of Equilibrium Output (Income) Fiscal Policy at Work: Multiplier EffectsThe Government Spending MultiplierThe Tax MultiplierThe Balanced-Budget MultiplierThe Federal BudgetThe Budget in 2007Fiscal Policy Since 1993: The Clinton and Bush Administrations The Federal Government DebtThe 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 StabilizersFiscal DragFull-Employment BudgetLooking AheadAppendix A: Deriving the Fiscal Policy Multipliers Appendix B: The Case in Which Tax Revenues Depend on Income CHAPTER OUTLINE The Government and Fiscal Policy PART V THE CORE OF MACROECONOMIC THEORY

4. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 4 of 39 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.

5. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 5 of 39 Government in the Economy discretionary fiscal policy Changes in taxes or spending that are the result of deliberate changes in government policy. net taxes (T) Taxes paid by firms and households to the government minus transfer payments made to households by the government. disposable, or after-tax, income (Y d ) Total income minus net taxes: Y - T. Government Purchases (G), Net Taxes (T), and Disposable Income (Y d ) disposable income ≡ total income − net taxes Y d ≡ Y − T

6. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 6 of 39 Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d )  FIGURE 24.1 Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income

7. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 7 of 39 Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d ) When government enters the picture, the aggregate income identity gets cut into three pieces: And aggregate expenditure (AE) equals:

8. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 8 of 39 Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d ) 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

9. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 9 of 39 Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d ) 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.

10. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 10 of 39 Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d ) Planned Investment The government can affect investment behavior through its tax treatment of depreciation and other tax policies.

11. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 11 of 39 Government in the Economy The Determination of Equilibrium Output (Income) Y = C + I + G TABLE 24.1 Finding Equilibrium for I = 100, G = 100, and T = 100 (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 Disequi- librium 300100200250  50 100 450  150 Output8 500100400 0100 600  100 Output8 70010060055050100 750  50 Output8 900100800700100 9000Equilibrium 1,1001001,000850150100 1,050+ 50Output9 1,3001001,2001,000200100 1,200+ 100Output9 1,5001001,4001,150250100 1,350+ 150Output9

12. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 12 of 39 Government in the Economy The Determination of Equilibrium Output (Income)  FIGURE 24.2 Finding Equilibrium Output/Income Graphically Because G and I are both fixed at 100, the aggregate expenditure function is the new consumption function displaced upward by I + G = 200. Equilibrium occurs at Y = C + I + G = 900.

13. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 13 of 39 Government in the Economy The Determination of Equilibrium Output (Income) The Saving/Investment Approach to Equilibrium saving/investment approach to equilibrium: S + T = I + G To derive this, we know that in equilibrium, aggregate output (income) (Y) equals planned aggregate expenditure (AE). By definition, AE equals C + I + G; and by definition, Y equals C + S + T. Therefore, at equilibrium C + S + T = C + I + G Subtracting C from both sides leaves: S + T = I + G

14. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 14 of 39 Fiscal Policy at Work: Multiplier Effects At this point, we are assuming that the government controls G and T. In this section, we will review three multipliers: Government spending multiplier Tax multiplier Balanced-budget multiplier

15. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 15 of 39 Fiscal Policy at Work: Multiplier Effects The Government Spending Multiplier government spending multiplier The ratio of the change in the equilibrium level of output to a change in government spending.

16. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 16 of 39 Fiscal Policy at Work: Multiplier Effects The Government Spending Multiplier TABLE 24.2 Finding Equilibrium After a Government Spending Increase of 50 (G Has Increased from 100 in Table 24.1 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 Output8 500100400 0100150650  150 Output8 70010060055050100150800  100 Output8 900100800700100 150950  50 Output8 1,1001001,0008501501001501,1000Equilibrium 1,3001001,2001,0002001001501,250+ 50Output 

17. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 17 of 39 Fiscal Policy at Work: Multiplier Effects The Government Spending Multiplier  FIGURE 24.3 The Government Spending Multiplier Increasing government spending by 50 shifts the AE function up by 50. As Y rises in response, additional consumption is generated. Overall, the equilibrium level of Y increases by 200, from 900 to 1,100.

18. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 18 of 39 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.

19. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 19 of 39 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 are exactly the same size as the initial change in G or T.

20. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 20 of 39 Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier TABLE 24.3 Finding Equilibrium After a Balanced-Budget Increase in G and T of 200 Each (Both G and T Have Increased from 100 in Table 24.1 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 Output8 700300400 100300800  100 Output8 900300600550100300950  50 Output8 1,1003008007001003001,1000Equilibrium 1,3003001,0008501003001,250+ 50Output9 1,5003001,2001,0001003001,400+ 100Output9

21. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 21 of 39 Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier TABLE 24.4 Summary of Fiscal Policy Multipliers Policy StimulusMultiplier Final Impact On Equilibrium Y Government spending multiplier Increase or decrease in the level of government purchases: ∆G Tax multiplierIncrease or decrease in the level of net taxes: ∆T Balanced-budget multiplier Simultaneous balanced-budget increase or decrease in the level of government purchases and net taxes: ∆G = ∆T 1

22. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 22 of 39 The Federal Budget federal budget The budget of the federal government. The “budget” is really three different budgets. First, it is a political document that dispenses favors to certain groups or regions and places burdens on others. Second, it is a reflection of goals the government wants to achieve. Third, the budget may be an embodiment of some beliefs about how (if at all) the government should manage the macroeconomy.

23. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 23 of 39 The Federal Budget The Budget in 2007 federal surplus (+) or deficit (  ) Federal government receipts minus expenditures.

24. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 24 of 39 The Economy’s Influence on the Government Budget Tax Revenues Depend on the State of the Economy Tax revenue, on the other hand, depends on taxable income, and income depends on the state of the economy, which the government does not completely control. 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.

25. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 25 of 39 The Economy’s Influence on the Government Budget Some Government Expenditures Depend on the State of the Economy Fiscal Policy In 2008 Congress Approves Economic-Stimulus Bill Wall Street Journal

26. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 26 of 39 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. 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.

27. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 27 of 39 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 the 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.

28. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 28 of 39 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 Y d ≡ 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.Saving/investment approach to equilibrium in an economy with government: S + T = I + G 6.Government spending multiplier ≡ 7.Tax multiplier ≡ 8.Balanced-budget multiplier ≡ 1

29. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 29 of 39 DERIVING THE FISCAL POLICY MULTIPLIERS A P P E N D I X A THE GOVERNMENT SPENDING AND TAX MULTIPLIERS

30. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 30 of 39 DERIVING THE FISCAL POLICY MULTIPLIERS 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) A P P E N D I X A

31. CHAPTER 24 The Government and Fiscal Policy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 31 of 39 DERIVING THE FISCAL POLICY MULTIPLIERS THE BALANCED-BUDGET MULTIPLIER A P P E N D I X 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: