Macro Chapter 24 - Govt and Fiscal Policy

The Government and
Fiscal Policy
CHAPTER OUTLINE
Government in the Economy
Government Purchases (G), Net Taxes (T), and Disposable
Income (Yd)
The Determination of Equilibrium Output (Income)
Fiscal Policy at Work: Multiplier Effects

The Government Spending Multiplier
The Tax Multiplier
The Balanced-Budget Multiplier
PART V The Core of Macroeconomic Theory
The Federal Budget
2012 Pearson Education
The Budget in 2009

Fiscal Policy Since 1993: The Clinton, Bush, and Obama
Administrations
The Federal Government Debt
The Economys Influence on the Government

Budget
Automatic Stabilizers and Destabilizers
Full-Employment Budget
Looking Ahead
Appendix A: Deriving the Fiscal Policy Multipliers
Appendix B: The Case in Which Tax Revenues
Depend on Income
1 of 42
Keyness analysis in The General

Theory, which suggest that
governments can use their taxing and
spending powers to increase
aggregate expenditure (and thereby
stimulate aggregate output) in
recession or depressions.
2 of 42
The government has a variety of

powers:
1.Regulating firms entry into and exit
from industry.
2.Setting standards of product quality
3.Setting minimum wage level
4.Regulating the disclosure of
information
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The government can affect

Macroeconomy through two policy
channels:
1.Fiscal policy The governments

spending and taxing policies in
other words, its budget policy.
Fiscal come from the root fisc, which
refers to treasury of government..
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Fiscal policy generally divided into

three categories:
1.Policies concerning government
purchases of goods and services.
2.Policies concerning taxes
3.Policies concerning transfer
payment ( unemployment
compensation, SSS benefits, welfare
payments, veterans benefits, etc
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2. Monetary policy The behavior of

the nations central bank, concerning
the nations money supply.
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There are some matters over which they exert great control
and some are beyond their control.
tax rates are controlled by government.
income of the household sector are not controlled by

the government.
Government controls corporate tax rates but not the
size of corporate profits.
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Discretionary fiscal policy Changes in taxes or spending

that are the result of deliberate changes in government
policy.
Government Purchases (G), Net Taxes (T), and Disposable Income (Yd)
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.
disposable income total income net taxes
Yd Y T
8 of 42

FIGURE 24.1
Adding Net Taxes (T)
and Government
Purchases (G) to the
Circular Flow of
Income
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The disposable income (Yd) of households must end up as
either consumption (C) or saving (S). Thus,
Yd C S
Because disposable income is aggregate income (Y) minus net

taxes (T), we can write another identity:
Y T C S
By adding T to both sides:
Y C S T
Planned aggregate expenditure (AE) is the sum of
consumption spending by households (C), planned investment
by business firms (I), and government purchases of goods and
services (G).
AE C I G
10 of 42

Government Purchases (G), Net Taxes (T), and
Disposable Income (Yd)
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
If G > T the govt will borrow to finance the
deficit
If G < T the govt is spending less than it is
collecting taxes, the government is
running a surplus.
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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
= a +now
b(Yhas
T)
Our consumption C
function
consumption
depending on disposable income instead of before-tax
income.
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Government Purchases (G), Net Taxes (T), and
Disposable Income (Yd)
Planned Investment
The government can affect investment

behavior through its tax treatment of
depreciation and other tax policies.
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Y = AE
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)
Unplanned
Planned
Planned
Inventory Adjustment
Output
Net Disposable Consumption Saving Investment Government Aggregate
Income
Change
Spending
S
(Income) Taxes
Spending Purchases Expenditure
to DisequiY
Y
T
C
=
100
+
.75
Y
Y
C
Y
(C
+
I
+
G)
Y
T
I
G
C+I+G
librium
d
d
d
300
500
100
100
200
400
250
400
50
0
100
100
100
100
450
600
150
100
Output
Output
700
100
600
550
50
100
100
750
50
Output
900
100
800
700
100
100
100
900
Equilibrium
1,100
100
1,000
850
150
100
100
1,050
+ 50
Output
1,300
100
1,200
1,000
200
100
100
1,200
+ 100
Output
1,500
100
1,400
1,150
250
100
100
1,350
+ 150
Output
14 of 42

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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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
17 of 42
governmentspendingmultiplier
MPS
government spending multiplier The ratio

of the change in the equilibrium level of output
to a change in government spending.
18 of 42

TABLE 24.2 Finding Equilibrium after a Government Spending Increase of 50 (G Has
Increased from 100 in Table 9.1 to 150 Here)
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
Unplanned
Inventory
Planned
Planned
Disposable
Change
Consumption Saving Investment Government Aggregate
Output
Net
Adjustment
Income
Spending
S
(Income) Taxes
Spending Purchases Expenditure Y (C + I +
to
Yd Y T C = 100 + .75 Yd Yd C
Y
T
I
G
C+I+G
G)
Disequilibrium
300
100
200
250
50
100
150
500
200
Output
500
100
400
400
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
1,300
100
1,200
1,000
200
100
150
1,250
+ 50
Equilibrium
Output
19 of 42

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.
20 of 42

The Tax Multiplier
tax multiplier The ratio of change in the equilibrium level of output to
a change in taxes.
M PS
Y (in itia l in c re a s e in a g g re g a te e x p e n d itu re )
Because the initial change in aggregate expenditure caused by a tax

change of T is (T MPC), we can solve for the tax multiplier by
substitution:
Y ( T MPC )
T MPC
MPS
MPS
Because a tax cut will cause an increase in consumption expenditures

and output and a tax increase will cause a reduction in consumption
expenditures and output, the tax multiplier is a negative multiplier:
taxmultiplier

MPC
MPS
21 of 42

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 balancedbudget 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.
balancedbudgetmultiplier 1
22 of 42

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 9.1 to 300 Here)
(1)
Output
(Income)
Y
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
Unplanned
Planned
Planned
Disposable
Inventory
Consumption
Net
Investment Government Aggregate
Adjustment
Income
Change
Spending
Taxes
Spending Purchases Expenditure
to
Yd Y T C = 100 + .75 Yd
T
I
G
C + I + G Y (C + I + G) 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
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
Equilibrium
23 of 42

TABLE 24.4 Summary of Fiscal Policy Multipliers
Policy Stimulus
Government
spending
multiplier
Increase or decrease in the

level of government
purchases: G
Tax multiplier Increase or decrease in the

level of net taxes: T
Balancedbudget
multiplier
Simultaneous balancedbudget
increase or decrease in the
level of government
purchases
and net taxes: G = T
Multiplier
1
M PS
M PC
M PS
Final Impact on
Equilibrium Y
1
MPS
MPC
MPS
24 of 42

A Warning
Although we have added government, the story told
about the multiplier is still incomplete and
oversimplified.
We have been treating net taxes (T) as a lump-sum,

fixed amount, whereas in practice, taxes depend on
income.
Appendix B to this chapter shows that the size of the
multiplier is reduced when we make the more realistic
assumption that taxes depend on income.
We continue to add more realism and difficulty to our
analysis in the chapters that follow.
25 of 42
The Economys Influence on the Government Budget

Automatic Stabilizers and Destabilizers
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.
automatic destabilizer Revenue and expenditure items in the

federal budget that automatically change with the state of the
economy in such a way as to destabilize GDP.
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.
26 of 42
The Economys Influence on the Government Budget

Full-Employment Budget
full-employment budget What the federal budget

would be if the economy were producing at the fullemployment 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.
27 of 42
CHAPTER 24 APPENDIX A
Deriving the Fiscal Policy Multipliers
The Government Spending and Tax Multipliers
We can derive the multiplier algebraically using our hypothetical

consumption function:
C a b (Y T )
The equilibrium condition is
Y C I G
By substituting for C, we get
Y a b (Y T ) I G
Y a bY bT I G
This equation can be rearranged to yield
Y bY a I G bT
Y (1 b ) a I G b T
Now solve for Y by dividing through by (1 b):
1
Y
(a I G bT )
1 b
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It is easy to show formally that the balanced-budget multiplier = 1.
increase in spending:
decrease in spending:
= net increase in spending
G
C T ( MPC )
G T ( MPC )
In a balanced-budget increase, G = T; so we can substitute:
net initial increase in spending:

G G (MPC) = G (1 MPC)
29 of 42
Because MPS = (1 MPC), the net initial increase in spending is:

G (MPS)
1
to this net initial
We can now apply the expenditure multiplier
MPS
increase in spending:
1
Y G ( MPS )
G
MPS
Thus, the final total increase in the equilibrium level of Y is just equal to the
initial balanced increase in G and T.
30 of 42
CHAPTER 24 APPENDIX B
The Case in Which Tax Revenues Depend on Income
FIGURE 24B.1 The Tax Function
This graph shows net taxes (taxes

minus transfer payments) as a
function of aggregate income.
Yd Y T
Yd Y (200 1 / 3Y )
Yd Y 200 1 / 3Y
C 100 .75Yd
C 100 .75(Y 200 1 / 3Y )
31 of 42
The Case in Which Tax Revenues Depend on Income
Y C I G
Y 100 .75(Y 200 1/ 3Y ) 100
100
{
1 4 4 4 4 2 4 4 4 43 {
I
G
C
Y 100 .75Y 150 25Y 100 100
Y 450 .5Y
.5Y 450
FIGURE 24B.2 Different Tax Systems
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.
32 of 42
The Case in Which Tax Revenues Depend on Incomes
The Government Spending and Tax Multipliers Algebraically
C a b (Y T )
C a b(Y T0 tY )
C a bY bT0 btY
Through substitution we get
Y a bY bT btY I G
1 4 44 2 4 4 43
C
0
Solving for Y:
1
1 b bt
(a I G b T0 )
33 of 42
The Case in Which Tax Revenues Depend on Incomes
The Government Spending and Tax Multipliers Algebraically
This means that a $1 increase in G or I (holding a and T0 constant) will

increase the equilibrium level of Y by
1
1 b bt
Holding a, I, and G constant, a fixed or lump-sum tax cut (a cut in T0) will
increase the equilibrium level of income by
b
1 b bt
34 of 42

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The Government and

Fiscal Policy at Work: Multiplier Effects

PART V The Core of Macroeconomic Theory

The Federal Budget

2012 Pearson Education

The Budget in 2009

The Economys Influence on the Government

PART V The Core of Macroeconomic Theory

Keyness analysis in The General

2012 Pearson Education

PART V The Core of Macroeconomic Theory

The government has a variety of

2012 Pearson Education

The government can affect

PART V The Core of Macroeconomic Theory

1.Fiscal policy The governments

2012 Pearson Education

PART V The Core of Macroeconomic Theory

Fiscal policy generally divided into

2012 Pearson Education

PART V The Core of Macroeconomic Theory

2. Monetary policy The behavior of

2012 Pearson Education

Government in the Economy

PART V The Core of Macroeconomic Theory

income of the household sector are not controlled by

2012 Pearson Education

Government in the Economy

Discretionary fiscal policy Changes in taxes or spending

PART V The Core of Macroeconomic Theory

Net taxes (T) Taxes paid by firms and households

2012 Pearson Education

Government in the Economy

PART V The Core of Macroeconomic Theory

2012 Pearson Education

Government in the Economy

PART V The Core of Macroeconomic Theory

Because disposable income is aggregate income (Y) minus net

2012 Pearson Education

Government in the Economy

PART V The Core of Macroeconomic Theory

Budget deficit The difference between what a

2012 Pearson Education

Government in the Economy

PART V The Core of Macroeconomic Theory

Adding Taxes to the Consumption Function

2012 Pearson Education

To modify our aggregate consumption

Government in the Economy

PART V The Core of Macroeconomic Theory

The government can affect investment

2012 Pearson Education

Government in the Economy

The Determination of Equilibrium Output (Income)

PART V The Core of Macroeconomic Theory

2012 Pearson Education

Government in the Economy

PART V The Core of Macroeconomic Theory

Because G and I are both fixed at

2012 Pearson Education

Government in the Economy

PART V The Core of Macroeconomic Theory

2012 Pearson Education

To derive this, we know that in equilibrium, aggregate