1. 1 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Prepared by: Fernando Quijano & Shelly Tefft CASE FAIR OSTER P R I N C I P L E S O F MACROECONOMICS T E N T H E D I T I O N

2. 2 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall

3. 3 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall CHAPTER OUTLINE 9 The Government and Fiscal Policy Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d ) The Determination of Equilibrium Output (Income) Fiscal Policy at Work: Multiplier Effects The Government Spending Multiplier The Tax Multiplier The Balanced-Budget Multiplier The Federal Budget The Budget in 2009 Fiscal Policy Since 1993: The Clinton, Bush, and Obama Administrations The Federal Government Debt The Economy’s 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

4. 4 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall fiscal policy The government’s spending and taxing policies. monetary policy The behavior of the Federal Reserve concerning the nation’s money supply.

5. 5 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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. disposable income ≡ total income − net taxes Y d ≡ Y − T Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d )

6. 6 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall  FIGURE 9.1 Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d )

7. 7 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall The disposable income (Y d ) of households must end up as either consumption (C) or saving (S). Thus, Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d ) Because disposable income is aggregate income (Y) minus net taxes (T), we can write another identity: By adding T to both sides: 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).

8. 8 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d )

9. 9 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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. Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d ) Adding Taxes to the Consumption Function

10. 10 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall The government can affect investment behavior through its tax treatment of depreciation and other tax policies. Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d ) Planned Investment

11. 11 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Y = C + I + G TABLE 9.1 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 Output ↑ 500100400 0100 600  100 Output ↑ 70010060055050100 750  50 Output ↑ 900100800700100 9000Equilibrium 1,1001001,000850150100 1,050+ 50Output ↓ 1,3001001,2001,000200100 1,200+ 100Output ↓ 1,5001001,4001,150250100 1,350+ 150Output ↓ Government in the Economy The Determination of Equilibrium Output (Income)

12. 12 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall  FIGURE 9.2 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. Government in the Economy The Determination of Equilibrium Output (Income)

13. 13 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 Government in the Economy The Determination of Equilibrium Output (Income) The Saving/Investment Approach to Equilibrium

14. 14 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 Fiscal Policy at Work: Multiplier Effects

15. 15 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall government spending multiplier The ratio of the change in the equilibrium level of output to a change in government spending. Fiscal Policy at Work: Multiplier Effects The Government Spending Multiplier

16. 16 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall TABLE 9.2 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) 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 Output ↑ 500100400 0100150650  150 Output ↑ 70010060055050100150800  100 Output ↑ 900100800700100 150950  50 Output ↑ 1,1001001,0008501501001501,1000Equilibrium 1,3001001,2001,0002001001501,250+ 50Output ↓ Fiscal Policy at Work: Multiplier Effects The Government Spending Multiplier

17. 17 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall  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. Fiscal Policy at Work: Multiplier Effects The Government Spending Multiplier

18. 18 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall tax multiplier The ratio of change in the equilibrium level of output to a change in taxes. Fiscal Policy at Work: Multiplier Effects The Tax Multiplier 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: 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:

19. 19 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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. Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier

20. 20 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall TABLE 9.3 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)(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 Output ↑ 700300400 100300800  100 Output ↑ 900300600550100300950  50 Output ↑ 1,1003008007001003001,1000Equilibrium 1,3003001,0008501003001,250+ 50Output ↓ 1,5003001,2001,0001003001,400+ 100Output ↓ Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier

21. 21 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall TABLE 9.4 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 Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier

22. 22 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier 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.

23. 23 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall federal budget The budget of the federal government. The “budget” is really three different budgets: It is a political document that dispenses favors to certain groups or regions and places burdens on others. It is a reflection of goals the government wants to achieve. The budget may be an embodiment of some beliefs about how (if at all) the government should manage the macroeconomy. The Federal Budget

24. 24 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall TABLE 9.5 Federal Government Receipts and Expenditures, 2009 (Billions of Dollars) AmountPercentage of Total Current receipts Personal income taxes828.737.2 Excise taxes and customs duties92.34.1 Corporate income taxes231.010.4 Taxes from the rest of the world12.30.6 Contributions for social insurance949.142.7 Interest receipts and rents and royalties48.22.2 Current transfer receipts from business and persons68.13.1 Current surplus of government enterprises − 4.9 − 0.2 Total2,224.9100.0 Current Expenditures Consumption expenditures986.428.6 Transfer payments to persons1596.146.2 Transfer payments to the rest of the world61.71.8 Grants-in-aid to state and local governments476.613.8 Interest payments272.37.9 Subsidies58.21.7 Total3,451.3100.0 Net federal government saving—surplus (+) or deficit (−) (Total current receipts − Total current expenditures) − 1,226.4 The Federal Budget The Budget in 2009

25. 25 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall federal surplus (+) or deficit (−) Federal government receipts minus expenditures. The Federal Budget The Budget in 2009

26. 26 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall  FIGURE 9.4 Federal Personal Income Taxes as a Percentage of Taxable Income, 1993 I–2010 I The Federal Budget Fiscal Policy Since 1993: The Clinton, Bush, and Obama Administrations

27. 27 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall  FIGURE 9.5 Federal Government Consumption Expenditures as a Percentage of GDP and Federal Transfer Payments and Grants-in-Aid as a Percentage of GDP, 1993 I–2010 I The Federal Budget Fiscal Policy Since 1993: The Clinton, Bush, and Obama Administrations

28. 28 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall  FIGURE 9.6 The Federal Government Surplus (+) or Deficit (–) as a Percentage of GDP, 1993 I–2010 I The Federal Budget Fiscal Policy Since 1993: The Clinton, Bush, and Obama Administrations

29. 29 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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. The Federal Budget The Federal Government Debt

30. 30 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall  FIGURE 9.7 The Federal Government Debt as a Percentage of GDP, 1993 I–2010 1 The Federal Budget The Federal Government Debt

31. 31 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 The negative effect on the economy that occurs when average tax rates increase because taxpayers have moved into higher income brackets during an expansion. The Economy’s Influence on the Government Budget Automatic Stabilizers and Destabilizers 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.

32. 32 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall E C O N O M I C S I N P R A C T I C E Governments Disagree on How Much More Spending Is Needed The U.S. economy is intertwined with the rest of the world. For that reason, U.S. government leaders are concerned not only with their own fiscal policies but also with those of other governments (and vice versa). President Obama was among the strongest advocates of additional stimulus by governments in a June 2010 summit of the G-20. Spending Fight at G-20 The Wall Street Journal

33. 33 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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. The Economy’s Influence on the Government Budget Full-Employment Budget

34. 34 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Looking Ahead We have now seen how households, firms, and the government interact in the goods market, how equilibrium output (income) is determined, and how the government uses fiscal policy to influence the economy. In the following two chapters, we analyze the money market and monetary policy—the government’s other major tool for influencing the economy.

35. 35 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall automatic destabilizers 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 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 a government: Y = C + I + G 5.Saving/investment approach to equilibrium in an economy with a government: S + T = I + G 6.Government spending multiplier ≡ 7.Tax multiplier ≡ 8.Balanced-budget multiplier ≡ 1 R E V I E W T E R M S A N D C O N C E P T S

36. 36 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall CHAPTER 9 APPENDIX A Deriving the Fiscal Policy Multipliers The Government Spending and Tax Multipliers We can derive the multiplier algebraically using our hypothetical consumption function: The equilibrium condition is By substituting for C, we get This equation can be rearranged to yield Now solve for Y by dividing through by (1 − b):

37. 37 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall It is easy to show formally that the balanced-budget multiplier = 1. increase in spending: − decrease in spending: = net increase in spending In a balanced-budget increase,  G =  T; so we can substitute: net initial increase in spending:  G −  G (MPC) =  G (1 − MPC) CHAPTER 9 APPENDIX A Deriving the Fiscal Policy Multipliers The Balanced-Budget Multiplier

38. 38 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Because MPS = (1 − MPC), the net initial increase in spending is:  G (MPS) We can now apply the expenditure multiplier to this net initial increase in spending: CHAPTER 9 APPENDIX A Deriving the Fiscal Policy Multipliers The Balanced-Budget Multiplier Thus, the final total increase in the equilibrium level of Y is just equal to the initial balanced increase in G and T.

39. 39 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall  FIGURE 9B.1 The Tax Function CHAPTER 9 APPENDIX B The Case in Which Tax Revenues Depend on Income This graph shows net taxes (taxes minus transfer payments) as a function of aggregate income.

40. 40 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 9B.2 Different Tax Systems CHAPTER 9 APPENDIX B The Case in Which Tax Revenues Depend on Income

41. 41 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall CHAPTER 9 APPENDIX B The Government Spending and Tax Multipliers Algebraically The Case in Which Tax Revenues Depend on Incomes Through substitution we get Solving for Y:

42. 42 of 42 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall CHAPTER 9 APPENDIX B The Government Spending and Tax Multipliers Algebraically The Case in Which Tax Revenues Depend on Incomes This means that a $1 increase in G or I (holding a and T 0 constant) will increase the equilibrium level of Y by Holding a, I, and G constant, a fixed or lump-sum tax cut (a cut in T 0 ) will increase the equilibrium level of income by