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

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© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 1 of 63

PowerPoint Lectures for

Principles of Economics, 9e

By

Karl E. Case, Ray C. Fair & Sharon M. Oster

; ;

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© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster

PART V THE CORE OF MACROECONOMIC THEORY

24The Government

and Fiscal Policy

Fernando & Yvonn Quijano

Prepared by:

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24Government 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 Multiplier The Balanced-Budget Multiplier

The Federal BudgetThe Budget in 2007Fiscal Policy Since 1993: The Clinton and

Bush AdministrationsThe Federal Government 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 EconomyAutomatic StabilizersFiscal DragFull-Employment Budget

Looking AheadAppendix A: Deriving the Fiscal Policy

Multipliers

Appendix B: The Case in Which Tax RevenuesDepend on Income

CHAPTER OUTLINE

The Government

and Fiscal Policy

PART V THE CORE OF MACROECONOMIC THEORY

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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.

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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.

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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.d. Monetary policy.Monetary policy.

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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 (Yd) Total income minus net taxes: Y - T.

Government Purchases (G), Net Taxes (T), and Disposable Income (Yd)

disposable income ≡ total income − net taxes

Yd ≡ Y − T

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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.

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Over which of the following categories does the government have more control?

a. Tax revenue.

b. Government expenditures.

c.c. Tax rates.Tax rates.

d. The size of corporate profits.

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FIGURE 24.1 Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income

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Select the best answer. Households use their disposable income (Yd) to do the following:

a. Consume.

b. Consume and save.

c. Consume, save, and pay taxes.

d. Consume, save, pay taxes, and buy imports.

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Select the best answer. Households use their disposable income (Yd) to do the following:

a. Consume.

b.b. Consume and save.Consume and save.

c. Consume, save, and pay taxes.

d. Consume, save, pay taxes, and buy imports.

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When government enters the picture, the aggregate income identity gets cut into three pieces:

Y Y Td

Y C Sd

Y T C S

Y C S T

And aggregate expenditure (AE) equals:

AE C I G

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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

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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 + bYd

or

C = a + b(Y − T)

Our consumption function now has consumption depending on disposable income instead of before-tax income.

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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

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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 + GC + I + G

d. G – T

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Planned Investment

The government can affect investment behavior through its tax treatment of depreciation and other tax policies.

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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

NetTaxes

T

DisposableIncome

Yd Y T

ConsumptionSpending

(C = 100 + .75 Yd)

SavingS

(Yd – C)

PlannedInvestmentSpending

I

GovernmentPurchases

G

PlannedAggregate

Expenditure C + I + G

UnplannedInventoryChange

Y (C + I + G)

Adjustmentto Disequi-

librium

300 100 200 250 50 100 100 450 150 Output500 100 400 400 0 100 100 600 100 Output700 100 600 550 50 100 100 750 50 Output900 100 800 700 100 100 100 900 0 Equilibrium

1,100 100 1,000 850 150 100 100 1,050 + 50 Output1,300 100 1,200 1,000 200 100 100 1,200 + 100 Output1,500 100 1,400 1,150 250 100 100 1,350 + 150 Output

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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.

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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

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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.

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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.c. Y = Y = aa + + bTbT + + II + + GG..

d. S + T = I + G.

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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

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The Government Spending Multiplier

1government spending multiplier

MPS

government spending multiplier The ratio of thechange in the equilibrium level of output to a change in government spending.

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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

NetTaxes

T

DisposableIncome

Yd Y T

ConsumptionSpending

(C = 100 + .75 Yd)

SavingS

(Yd – C)


I

GovernmentPurchases

G

PlannedAggregate



Y (C + I + G)

AdjustmentTo

Disequilibrium

300 100 200 250 50 100 150 500 200 Output

500 100 400 400 0 100 150 650 150 Output

700 100 600 550 50 100 150 800 100 Output

900 100 800 700 100 100 150 950 50 Output

1,100 100 1,000 850 150 100 150 1,100 0 Equilibrium

1,300 100 1,200 1,000 200 100 150 1,250 + 50 Output

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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.

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How much of an increase in government spending would be required to generate a $200 billion increase in the equilibrium level of output?

a.a. An amount less than $200 billion in government An amount less than $200 billion in government spending.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.

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FIGURE 24.3 The GovernmentSpending MultiplierIncreasing 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.

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The Tax Multiplier

tax multiplier The ratio of change in the equilibrium level of output to a change in taxes.

tax multiplier MPC

MPS

YM P S

( in itia l in c rease in ag g reg a te ex p en d itu re )

1

1( )

MPCY T MPC T

MPS MPS

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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

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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.d. – ∆T – ∆T ** ((b/b/11 – b – b))

e. C + S = I + G

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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.

1balanced-budget multiplier

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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

NetTaxes

T

DisposableIncome

Yd Y T

ConsumptionSpending

(C = 100 + .75 Yd)


I

GovernmentPurchases

G

PlannedAggregate



Y (C + I + G)

AdjustmentTo

Disequilibrium

500 300 200 250 100 300 650 150 Output

700 300 400 400 100 300 800 100 Output

900 300 600 550 100 300 950 50 Output

1,100 300 800 700 100 300 1,100 0 Equilibrium

1,300 300 1,000 850 100 300 1,250 + 50 Output

1,500 300 1,200 1,000 100 300 1,400 + 100 Output

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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).

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What happens when there is a simultaneous increase in government spending of $100 and a lump-sum tax of $100?

a.a. Equilibrium income would increase by $100, or the Equilibrium income would increase by $100, or the amount of increase in amount of increase in GG..

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).

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TABLE 24.4 Summary of Fiscal Policy Multipliers

Policy Stimulus MultiplierFinal Impact OnEquilibrium Y

Government spendingmultiplier

Increase or decrease in thelevel of governmentpurchases: ∆G

Tax multiplier Increase or decrease in thelevel of net taxes: ∆T

Balanced-budgetmultiplier

Simultaneous balanced-budgetincrease or decrease in thelevel of government purchasesand net taxes: ∆G = ∆T

1

1

M P S

M P C

M P S

1 G

MPS

MPC

TMPS

G

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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.

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The Federal Budget

The Budget in 2007

TABLE 24.5 Federal Government Receipts and Expenditures, 2007 (Billions of Dollars)Amount Percentage Of Total

ReceiptsPersonal income taxes 1,162.1 43.5Excise taxes and customs duties 99.9 3.7Corporate income taxes 380.8 14.3Taxes from the rest of the world 13.4 0.5Contributions for social insurance 953.0 35.7Interest receipts and rents and royalties 25.1 0.9Current transfer receipts from business and persons 39.4 1.5Current surplus of government enterprises − 2.3 − 0.0

Total 2,671.4 100.0Current Expenditures

Consumption expenditures 856.0 29.6Transfer payments to persons 1,270.7 43.9Transfer payments to the rest of the world 38.6 1.3Grants-in-aid to state and local governments 377.5 13.1Interest payments 302.4 10.5Subsidies 46.7 1.6

Total 2,892.0 100.0Net federal government saving—surplus (+) or deficit (−)

(Total current receipts − Total current expenditures) − 220.6Source: U.S. Department of Commerce, Bureau of Economic Analysis.

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The Federal Budget

The Budget in 2007

federal surplus (+) or deficit () Federal government receipts minus expenditures.

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The Federal Budget

Fiscal Policy Since 1993: The Clinton and Bush Administrations

FIGURE 24.4 Federal Personal Income Taxes as a Percentage of Taxable Income, 1993 I–2007 IV

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The Federal Budget


FIGURE 24.5 Federal Government Consumption Expenditures as a Percentage of GDP and Federal Transfer Payments and Grants-in-Aid as a Percentage of GDP, 1993 I–2007 IV

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The Federal Budget


FIGURE 24.6 The Federal Government Surplus (+) or Deficit (–) as a Percentage of GDP, 1993 I–2007 IV

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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.

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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.d. All of the above.All of the above.

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The Federal Budget

The Federal Government Debt

federal debt The total amount owed by the federal government.

privately held federal debt The privately held(non-government-owned) debt of the U.S. government.

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The Federal Budget

The Federal Government Debt

FIGURE 24.7 The Federal Government Debt as a Percentage of GDP, 1993 I–2007 IV

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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.

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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.

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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.b. Turned into a surplus during the two Clinton Turned into a surplus during the two Clinton administrations.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.

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Some Government Expenditures Depend on the State of the Economy

Fiscal Policy In 2008

Congress Approves Economic-Stimulus Bill

Wall Street Journal

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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.

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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.

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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 The government does not have complete control of either the revenue side or the expenditure side of the either the revenue side or the expenditure side of the budget.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.

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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.

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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.

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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.d. Equal to the structural deficit.Equal to the structural deficit.

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automatic stabilizers

balanced-budget multiplier

budget deficit

cyclical deficit

discretionary fiscal policy

disposable, or after-tax,

income (Yd)

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. 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

MPC

MPS

MPS

1

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DERIVING THE FISCAL POLICY MULTIPLIERS

A P P E N D I X A

THE GOVERNMENT SPENDING AND TAX MULTIPLIERS

Y C I G

C a b Y T ( )

Y a b Y T I G ( )

Y a bY bT I G Y bY a I G bT Y b a I G bT( )1

)(1

1bTGIa

b Y

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THE BALANCED-BUDGET MULTIPLIER

The balanced-budget multiplier is found by combining the effects of government spending and taxes:

Gincrease in spending:( )C T MPC - decrease in spending:( )G T MPC = 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

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THE BALANCED-BUDGET MULTIPLIER

A P P E N D I X A

1( )Y G MPS G

MPS

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:

MPS

1

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THE CASE IN WHICH TAX REVENUES DEPEND ON INCOME

A P P E N D I X B

TYYd

)3/1200( YYYd

YYYd 3/1200

dYC 75.100

)3/1200(75.100 YYC

FIGURE 24B.1 The Tax Function

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A P P E N D I X B

When taxes are strictly lump-sum (T = 100) and do not depend on income, the aggregate expenditure function is steeper than when taxes depend on income.

FIGURE 24B.2 Different Tax Systems

GICY

100 .75( 200 1/3 ) 100 100Y Y YI GC

4505.

5.450

10010025.15075.100

Y

YY

YYY

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A P P E N D I X B

THE GOVERNMENT SPENDING AND TAX MULTIPLIERS ALGEBRAICALLY

C a b Y T ( )

0C a bY bT btY

0( )C a b Y T tY

0Y a bY bT btY I G

C

Yb bt

a I G bT

1

1 0( )

1

1 b bt

Documents

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