Transcript Principles of Economics, Case and Fair,9e

PART III THE CORE OF MACROECONOMIC THEORY
9
The Government
and Fiscal Policy
CHAPTER OUTLINE
Government in the Economy
Fiscal Policy at Work: Multiplier Effects
The Federal Budget
The Economy’s Influence on the
Government Budget
Adapted from:
Fernando & Yvonn Quijano
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9.1 Government in the Economy
CHAPTER 9 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.
This chapter focuses on fiscal policy, or more
specifically, discretionary fiscal policy (i.e. changes in
taxes or spending that are the result of deliberate
decisions by the government).
However, in reality, taxes and spending often go up or
down in response to changes in the economy.
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9.1 Government in the Economy
net taxes (T) Taxes paid by firms and households to the
government minus transfer payments made to households
by the government.
CHAPTER 9 The Government and Fiscal Policy
disposable income ≡ total income − net taxes
Yd ≡ Y − T
At this stage, for simplicity, we assume T is a lump-sum
tax. But in practice, tax revenues depend on income.
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9.1 Government in the Economy
When government enters the picture, the aggregate income identity
gets cut into three pieces:
CHAPTER 9 The Government and Fiscal Policy
Yd  C  S
Y  T  C S
Y  C S  T
and planned aggregate expenditure (AE) equals:
AE  C  I  G
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9.1 Government in the Economy
Adding Taxes to the Consumption Function
In a 2-sector economy,
C = a + bY
where b is MPC
CHAPTER 9 The Government and Fiscal Policy
In a 3-sector economy, consumption depends on disposable income.
C = a + bYd
or
C = a + b(Y − T)
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9.1 Government in the Economy
The Determination of Equilibrium Output (Income)
At equilibrium,
CHAPTER 9 The Government and Fiscal Policy
Given that
Y = AE
AE  C + I + G
 Y=C+I+G
If Y > C + I + G, there will be unplanned increases in inventories.
Firms will respond by reducing output. As output falls, income falls,
consumption falls, and so on, until equilibrium is restored.
If Y < C + I + G, there will be unplanned reductions in inventories.
Firms will respond by increasing output. As output increases, income
rises, consumption rises, and so on, until equilibrium is restored,
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9.1 Government in the Economy
The Determination of Equilibrium Output (Income)
CHAPTER 9 The Government and Fiscal Policy
TABLE 9.1 Finding Equilibrium for I = 100, G = 100, and T = 100
(1)
(2)
Output
(Income)
Y
Net
Taxes
T
300
500
700
900
1,100
1,300
1,500
100
100
100
100
100
100
100
(3)
(4)
(5)
Disposable
Consumption
Saving
Income
Spending
S
Yd  Y  T (C = 100 + .75 Yd) (Yd – C)
200
400
600
800
1,000
1,200
1,400
250
400
550
700
850
1,000
1,150
(6)
(7)
Planned
Investment Government
Spending
Purchases
I
G
 50
0
50
100
150
200
250
100
100
100
100
100
100
100
100
100
100
100
100
100
100
(8)
(9)
(10)
Planned
Aggregate
Expenditure
C+I+G
Unplanned
Inventory
Change
Y  (C + I + G)
Adjustment
to Disequilibrium
450
600
750
900
1,050
1,200
1,350
 150
 100
 50
0
+ 50
+ 100
+ 150
Output 
Output 
Output 
Equilibrium
Output 
Output 
Output 
C = 100 + 0.75Yd
= 100 + 0.75 (Y – 100)
= 100 + 0.75Y – 75
= 25 + 0.75Y
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9.1 Government in the Economy
The Determination of Equilibrium Output (Income)
 FIGURE 9.2 Finding Equilibrium
Output/Income Graphically
CHAPTER 9 The Government and Fiscal Policy
The new consumption function is
C = 25 + 0.75Y.
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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9.1 Government in the Economy
The Determination of Equilibrium Output (Income)
CHAPTER 9 The Government and Fiscal Policy
From Table 9.1, I = 100, G = 100, T = 100 (G = T is balance budget)
C = 100 + 0.75Yd
= 100 + 0.75 (Y – T)
= 25 + 0.75Y
At equilibrium,
Y=C+I+G
= (25 + 0.75Y) + 100 + 100
= 225 + 0.75Y
0.25Y = 225
Y = 225 / 0.25
= 900
 The equilibrium level of output is 900.
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9.1 Government in the Economy
The Determination of Equilibrium Output (Income)
The Saving/Investment Approach to Equilibrium
CHAPTER 9 The Government and Fiscal Policy
At equilibrium,
Recall that
Since
Y = AE
YC+S+T
AE  C + I + G
Y = AE
C+S+T=C+I+G
S+T=I+G
We will now use this approach to find equilibrium output based on
the data from Table 9.1.
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9.1 Government in the Economy
The Determination of Equilibrium Output (Income)
CHAPTER 9 The Government and Fiscal Policy
From Table 9.1, I = 100, G = 100, T = 100 (G = T is balance budget)
Given that
C = 100 + 0.75Yd
Since
Yd = C + S
= (100 + 0.75Yd) + S
S = -100 + 0.25Yd
At equilibrium,
S+T=I+G
-100 + 0.25(Y – T) + T = I + G
-100 + 0.25(Y – 100) + 100 = 100 + 100
0.25Y – 25 = 200
0.25Y = 225
Y = 225 / 0.25
= 900
 The equilibrium level of output is 900.
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9.2 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:
CHAPTER 9 The Government and Fiscal Policy
Government spending multiplier (Y/G)
Tax multiplier (Y/T)
Balanced-budget multiplier
We also assume that T is lump-sum tax.
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9.2 Fiscal Policy at Work: Multiplier Effects
(1) The Government Spending Multiplier
CHAPTER 9 The Government and Fiscal Policy
When the government increases spending by 50 (G = 50), how much
will equilibrium output Y increase?
Using the same data as Table 9.1. I = 100, T = 100, but G = 150
(increased by 50).
C = 100 + 0.75Yd = 25 + 0.75Y
At equilibrium,
Y=C+I+G
= (25 + 0.75Y) + 100 + 150
= 275 + 0.75Y
0.25Y = 275
Y = 275 / 0.25
= 1100
 The equilibrium level of output increases by 200 (from 900 to 1100).
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9.2 Fiscal Policy at Work: Multiplier Effects
(1) The Government Spending Multiplier
CHAPTER 9 The Government and Fiscal Policy
When G = 50, Y increases by 200. How many times?
Government spending multiplier = Y/ G
= 200/50
= 4 times
We will later demonstrate how to derive the formula for this multiplier.
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9.2 Fiscal Policy at Work: Multiplier Effects
The Government Spending Multiplier
CHAPTER 9 The Government and Fiscal Policy
 FIGURE 9.3 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.
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9.2 Fiscal Policy at Work: Multiplier Effects
(2) The Tax Multiplier
CHAPTER 9 The Government and Fiscal Policy
Instead of increasing G, the government cuts taxes by 50 (T = -50).
How much will equilibrium output Y increase?
Using the same data as Table 9.1. I = 100, G = 100, but T = 50
(decreased by 50).
C = 100 + 0.75Yd = 100 + 0.75(Y – 50) = 62.5 + 0.75Y
At equilibrium,
Y=C+I+G
= (62.5 + 0.75Y) + 100 + 100
= 262.5 + 0.75Y
0.25Y = 262.5
Y = 262.5/ 0.25
= 1050
 The equilibrium level of output increases by 150 (from 900 to 1050).
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9.2 Fiscal Policy at Work: Multiplier Effects
(2) The Tax Multiplier
CHAPTER 9 The Government and Fiscal Policy
When T = -50, Y increases by 150. How many times?
Tax multiplier = Y/ T
= 150/-50
= -3 times
We will later demonstrate how to derive the formula for this multiplier.
Why is the tax multiplier smaller (-3) than the government spending
multiplier (4)?
When taxes are cut, it affects AE only through C by a fraction of T *
MPC. For instance, when taxes are cut by 50, C only increases by 50 x
0.75 = 37.5.
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9.2 Fiscal Policy at Work: Multiplier Effects
(2) The Tax Multiplier
For instance,
CHAPTER 9 The Government and Fiscal Policy
When T = 100,
When T = 50,
C = 25 + 0.75Y
C = 62.5 + 0.75Y
Suggesting that after tax cut of 50, the consumption function, and
hence AE function only moves up by 37.5 (compared with Figure 9.3,
slide 15)
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9.2 Fiscal Policy at Work: Multiplier Effects
(3) The Balanced-Budget Multiplier
CHAPTER 9 The Government and Fiscal Policy
What if now the government wants to increase output through G, but does
not want to borrow to finance this spending. In this case, the increased
spending has to be accompanied by increases in taxes, i.e. a balance budget
(G = T). How much will equilibrium output Y increase?
Using the same data as Table 9.1. I = 100, but G = 300 (increased by 200),
and T = 300 (increased by 200)
C = 100 + 0.75Yd = 100 + 0.75(Y – 300) = -125 + 0.75Y
At equilibrium,
Y=C+I+G
= (-125 + 0.75Y) + 100 + 300
= 275 + 0.75Y
0.25Y = 275
Y = 275/ 0.25
= 1100
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9.2 Fiscal Policy at Work: Multiplier Effects
(3) The Balanced-Budget Multiplier
The equilibrium level of output increases by 200 (from 900 to 1100).
CHAPTER 9 The Government and Fiscal Policy
In other words, 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.
We will later demonstrate how to derive this multiplier.
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9.3 Deriving the multipliers when tax is fixed (lump sum)
In a 3-sector economy,
C = a + bYd
where b is MPC
C  a  b(Y  T )
CHAPTER 9 The Government and Fiscal Policy
At equilibrium,
Y  C I  G
Y  a  b(Y  T )  I  G
Y  a  bY  bT  I  G
Y  bY  a  I  G  bT
Y (1 b)  a  I  G  bT
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9.3 Deriving the multipliers when tax is fixed (lump sum)
Investment multiplier:
CHAPTER 9 The Government and Fiscal Policy
Government spending multiplier:
Tax multiplier:
Balanced-budget multiplier:
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9.3 Deriving the multipliers when tax is fixed (lump sum)
Back to our example on slides 13-14. When the government increases
spending by 50 (G = 50), how much will equilibrium output Y
increase?
CHAPTER 9 The Government and Fiscal Policy
Given that C = 100 + 0.75Yd, so MPC = 0.75
Government spending multiplier:
So, when G increases by 50, Y will increase 4 times, i.e. 4 x 50 = 200
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9.3 Deriving the multipliers when tax is fixed (lump sum)
Back to our example on slides 16-17. When the government cuts taxes
by 50 (T = -50), how much will equilibrium output Y increase?
CHAPTER 9 The Government and Fiscal Policy
Given that C = 100 + 0.75Yd, so MPC = 0.75
Tax multiplier:
So, when T decreases by 50, Y will increase 3 times, i.e. 3 x 50 = 150
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9.3 Deriving the multipliers when tax is fixed (lump sum)
Back to our example on slides 19-20. When the government increases
spending by 200 (G = 200) and at the same raises taxes by 200 (T =
200), how much will equilibrium output Y increase?
CHAPTER 9 The Government and Fiscal Policy
Given that C = 100 + 0.75Yd, so MPC = 0.75
Given that government spending multiplier is 4,
Y = G x 4 times = 200 x 4 = 800
Given that tax multiplier is -3,
Y = T x -3 times = 200 x -3 = -600
Net increase in Y = 800 – 600 = 200 (the same as G or T)
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9.3 Deriving the multipliers when tax is fixed (lump sum)
Question:
CHAPTER 9 The Government and Fiscal Policy
Suppose that the economy is sitting at the equilibrium output Y of 900.
Given the high employment rate, you are asked to present proposal for
increasing the present output to 1100. Your options of fiscal policy
include:
(1) Increase G only
(2) Cut T only
(3) Increase G but it must be matched by the same amount of
increases in T (to maintain a balance budget)
Assume that the MPC in the economy is 0.75.
The answers are: (1) G = 50, (2) T = -66.67, (3) G = T = 200
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9.4 Deriving the multipliers when tax depends on income
Government sets tax rates, but tax revenues depend on taxable income,
and income depends on the state of the economy.
CHAPTER 9 The Government and Fiscal Policy
Suppose
In a 3-sector economy,
T = T0 + t Y
where t is the tax rate
C = a + bYd
where b is MPC
C  a  b(Y  T )
C  a  b(Y  T0  tY )
C  a  bY  bT0  btY
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9.4 Deriving the multipliers when tax depends on income
Y  C I  G
CHAPTER 9 The Government and Fiscal Policy
At equilibrium,
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CHAPTER 9 The Government and Fiscal Policy
9.4 Deriving the multipliers when tax depends on income
Suppose
T0 = -200 (transfer payments when income is zero)
t = 1/3
Tax function:
T = -200 + 1/3 Y
(Assume G = 100, I = 100)
Yd  Y  T
Yd  Y  (200 1 / 3Y )
Yd  Y  2001/ 3Y
Consumption function:
C  100 .75Yd
C  100 .75(Y  200 1 / 3Y )
No matter how taxes are
calculated, MPC (out of
disposable income) is still the
same. In this case, MPC = 0.75
C = 100 + 0.75Y + 150 – 0.25Y
C = 250 + 0.50Y
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9.4 Deriving the multipliers when tax depends on income
At equilibrium,
Y=C+I+G
= 250 + 0.50Y + 100 + 100
0.5Y = 450
CHAPTER 9 The Government and Fiscal Policy
Y = 450/0.5 = 900
Scenario 1, if G increases to 300 (G = 200), what is the new equilibrium Y?
Answer: New Y = 1300 (Y = 1300 – 900 = 400), implying the spending
multiplier is 2 (i.e. 400/200).
Double check the multiplier using the derived formula, when MPC=0.75, and
t=1/3. Do you get 2?
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9.4 Deriving the multipliers when tax depends on income
Scenario 2, if the government cuts lump-sum tax T0 to 600 ( T0 = -400), what
is the new equilibrium Y?
CHAPTER 9 The Government and Fiscal Policy
Answer: New Y = 1500 (Y = 1500 – 900 = 600), implying the tax multiplier is
-1.5 (i.e. 600/-400).
Hint: The new tax function is T = -600 + 1/3 Y
Double check the multiplier using the derived formula, when MPC=0.75, and
t=1/3. Do you get -1.5?
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9.5 The Federal Budget
CHAPTER 9 The Government and Fiscal Policy
federal budget The budget of the federal
government.
budget deficit/surplus The difference between
what a government spends and what it collects in
taxes in a given period.
If G > T, budget deficit
If G < T, budget surplus
News The Malaysia 2010 budget can be downloaded from
http://bajet.treasury.gov.my/index_bi.html
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9.5 The Federal Budget
CHAPTER 9 The Government and Fiscal Policy
U.S. Fiscal Policy Since 1993
 FIGURE 9.4 Federal Personal Income Taxes as a Percentage of Taxable Income, 1993 I–2007 IV
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9.5 The Federal Budget
CHAPTER 9 The Government and Fiscal Policy
U.S. Fiscal Policy Since 1993
 FIGURE 9.6 The Federal Government Surplus (+) or Deficit (–) as a Percentage of GDP,
1993 I–2007 IV
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9.5 The Federal Budget
CHAPTER 9 The Government and Fiscal Policy
U.S. Federal Government Debt
 FIGURE 9.7 The Federal Government Debt as a Percentage of GDP, 1993 I–2007 IV
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