Transcript Chapter 20: The Government and Fiscal Policy

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.
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Principles of Economics, 6/e
Karl Case, Ray Fair
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.
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Karl Case, Ray Fair
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.
Yd  Y  T
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Adding Net Taxes (T) and Government Purchases
(G) to the Circular Flow of Income
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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:
Yd  Y  T
Yd  C  S
Y  T  C S
Y  C S  T
• And aggregate expenditure (AE) equals:
AE  C  I  G
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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:
Budget deficit  G  T
• 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.
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Adding Taxes to the
Consumption Function
C  a  bY
C  a  bYd
Yd  Y  T
C  a  b( Y  T )
• With taxes a part of the picture, the
aggregate consumption function is a
function of disposable, or after-tax,
income.
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Equilibrium Output: Y = C + I + G
C  100 .75Yd C  100 .75( Y  T )
Finding Equilibrium for I = 100, G = 100, and T = 100
(All Figures in Billions of Dollars)
(1)
(2)
(3)
OUTPUT
NET
DISPOSABLE
(INCOME) TAXES
INCOME
Y
T
Yd / Y  T
(4)
(5)
CONSUMPTION
SPENDING
(C = 100 + .75 Yd)
SAVING
S
(Yd – C)
(6)
(7)
(8)
(9)
(10)
PLANNED
PLANNED
UNPLANNED
INVESTMENT GOVERNMENT AGGREGATE INVENTORY
ADJUSTMENT
SPENDING
PURCHASES EXPENDITURE
CHANGE
TO
I
G
C+I+G
Y  (C + I + G) DISEQUILIBRIUM
300
100
200
250
 50
100
100
450
 50
Output8
500
100
400
400
0
100
100
600
 100
Output8
700
100
600
550
50
100
100
750
 50
Output8
900
100
800
700
100
100
100
900
0
1,100
100
1,000
850
150
100
100
1,050
+ 50
Output9
1,300
100
1,200
1,000
200
100
100
1,200
+ 100
Output9
1,500
100
1,400
1,150
250
100
100
1,350
+ 150
Output9
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Karl Case, Ray Fair
Equilibrium
Finding Equilibrium
Output/Income Graphically
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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,
AE  C  I  G
Y  C S  T
C S  T  C I  G
S T  I  G
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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.
1
Government spending multiplier 
MPS
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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)
OUTPUT
NET
DISPOSABLE
(INCOME) TAXES
INCOME
Y
T
Yd / Y  T
(4)
(5)
CONSUMPTION
SPENDING
(C = 100 + .75 Yd)
SAVING
S
(Yd – C)
(6)
(7)
(8)
(9)
(10)
PLANNED
PLANNED
UNPLANNED
INVESTMENT GOVERNMENT AGGREGATE INVENTORY
ADJUSTMENT
SPENDING
PURCHASES EXPENDITURE
CHANGE
TO
I
G
C+I+G
Y  (C + I + G) DISEQUILIBRIUM
300
100
200
250
 50
100
150
500
 200
Output8
500
100
400
400
0
100
150
650
 150
Output8
700
100
600
550
50
100
150
800
 100
Output8
900
100
800
700
100
100
150
950
 50
Output8
1,100
100
1,000
850
150
100
150
1,100
0
1,300
100
1,200
1,000
200
100
150
1,250
+ 50
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Equilibrium
Output9
The Government Spending Multiplier
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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.
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The Tax Multiplier
 1 
 Y  (initial increase in aggregate expenditure)  

 MPS 
 1 
 MPC 
 Y  (   T  MPC )  
   T  

 MPS 
 MPS 
 MPC 
Tax multiplier   

 MPS 
• 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.
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Karl Case, Ray Fair
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.
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Karl Case, Ray Fair
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 = 100 + .75 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
300
650
 150
Output8
700
300
400
400
100
300
800
 100
Output8
900
300
600
550
100
300
950
 50
Output8
1,100
300
800
700
100
300
1,100
0
1,300
300
1,000
850
100
300
1,250
+ 50
Output9
1,500
300
1,200
1,000
100
300
1,400
+ 100
Output9
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Principles of Economics, 6/e
Karl Case, Ray Fair
Equilibrium
Fiscal Policy Multipliers
Summary of Fiscal Policy Multipliers
POLICY STIMULUS
MULTIPLIER
Governmentspending
multiplier
Increase or decrease in the
level of government
purchases:
1
MPS
Tax multiplier
Increase or decrease in the
level of net taxes:
 MPC
MPS
Balancedbudget
multiplier
Simultaneous balanced-budget
increase or decrease in the
level of government purchases
and net taxes:
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1
FINAL IMPACT ON
EQUILIBRIUM Y
G
T 
1
MPS
 MPC
MPS
G
Karl Case, Ray Fair
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:
Open-economy equilibrium: Y  C  I  G  ( X  M )
• 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.
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Karl Case, Ray Fair
The Federal Budget
Federal Government Receipts and Expenditures, 2000 (Billions of Dollars)
AMOUNT
PERCENTAGE
OF TOTAL
Receipts
Personal taxes
Corporate taxes
Indirect business taxes
Contributions for social insurance
Total
774.4
211.9
91.3
645.9
1,723.4
44.9
12.3
5.3
37.5
100.0
Current Expenditures
Consumption
Transfer payments
Grants-in-aid to state and local governments
Net interest payments
Net subsidies of government enterprises
Total
Current Surplus (+) or deficit () (Receipts  Current Expenditures)
463.8
795.5
224.2
230.3
38.4
1,752.2
 28.8
26.5
45.4
12.8
13.1
2.2
100.0
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
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The Federal Government Surplus/Deficit as
a Percentage of GDP, 1970 I2000 IV
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The Federal Government Debt as a
Percentage of GDP, 1970 I2000 IV
• The percentage began to fall in the mid 1990s.
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Karl Case, Ray Fair
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.
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Karl Case, Ray Fair
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.
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Karl Case, Ray Fair
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 fullemployment level of output.
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Karl Case, Ray Fair
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.
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Principles of Economics, 6/e
Karl Case, Ray Fair
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:
Y  a  bY  bT  btY  I  G
Y  C I  G
C  a  b(Y  T ) Y  bY  btY  a  bT0  I  G
Y (1  b  bt )  a  bT0  I  G
Yd  Y  T
1
T  T0  tY
Y
(a  bT0  I  G )
1  b  bt
I  I0
multiplier
value of autonomous
expenditures
G  G0
0
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Principles of Economics, 6/e
Karl Case, Ray Fair
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
then:
•
 Y  MPC
Y
1

=
and
T
MPS
 G MPS
Tax
multiplier
1
 MPC MPS


1
MPS
MPS
MPS
In words, a simultaneous increase in government
spending by $1 and lump-sum taxes by $1 will
increase equilibrium income by $1.
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Principles of Economics, 6/e
Karl Case, Ray Fair
Appendix B:
The government spending and tax multipliers
• The government spending and tax multipliers are
derived algebraically as follows:
Y  C I  G
C  a  b(Y  T )
Yd  Y  T
T  T0
I  I0
G  G0
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Y  a  b(Y  T )  I  G
Y  a  bY  bT  I  G
Y  bY  a  bT  I  G
Y (1 b)  a  bT  I  G
1
Y 
(a  bT  I  G )
1 b
*
multiplier
Principles of Economics, 6/e
value of autonomous
expenditures
Karl Case, Ray Fair