1. 1 of 40 Prepared by: Fernando Quijano w/Shelly Tefft CASE  FAIR  OSTER PRINCIPLES OF ECONOMICS E L E V E N T H E D I T I O N PEARSON

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3. 3 of 40 © 2014 Pearson Education, Inc. CHAPTER OUTLINE 24 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 2012 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 40 © 2014 Pearson Education, Inc. 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 40 © 2014 Pearson Education, Inc. 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 40 © 2014 Pearson Education, Inc.  FIGURE 24.1 Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income

7. 7 of 40 © 2014 Pearson Education, Inc. The disposable income (Y d ) of households must end up as either consumption (C) or saving (S). Thus, 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 40 © 2014 Pearson Education, Inc. 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 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. Adding Taxes to the Consumption Function

9. 9 of 40 © 2014 Pearson Education, Inc. The government can affect investment behavior through its tax treatment of depreciation and other tax policies. Planned investment depends on the interest rate, both of which we continue to assume are fixed for purposes of this chapter. Planned Investment

10. 10 of 40 © 2014 Pearson Education, Inc. 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 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− 50100 450− 150Output ↑ 500100400 0100 600− 100Output ↑ 70010060055050100 750− 50Output ↑ 900100800700100 9000Equilibrium 1,1001001,000850150100 1,050+ 50Output ↓ 1,3001001,2001,000200100 1,200+ 100Output ↓ 1,5001001,4001,150250100 1,350+ 150Output ↓ The Determination of Equilibrium Output (Income)

11. 11 of 40 © 2014 Pearson Education, Inc.  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.

12. 12 of 40 © 2014 Pearson Education, Inc. 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 The Saving/Investment Approach to Equilibrium

13. 13 of 40 © 2014 Pearson Education, Inc. 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 government spending multiplier The ratio of the change in the equilibrium level of output to a change in government spending. The Government Spending Multiplier

14. 14 of 40 © 2014 Pearson Education, Inc. 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 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 ↓

15. 15 of 40 © 2014 Pearson Education, Inc.  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.

16. 16 of 40 © 2014 Pearson Education, Inc. tax multiplier The ratio of change in the equilibrium level of output to a change in taxes. 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:

17. 17 of 40 © 2014 Pearson Education, Inc. 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. The Balanced-Budget Multiplier

18. 18 of 40 © 2014 Pearson Education, Inc. 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 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 500300200250100300650−150Output ↑ 700300400 100300800−100Output ↑ 900300600550100300950−50Output ↑ 1,1003008007001003001,1000Equilibrium 1,3003001,0008501003001,250+ 50Output ↓ 1,5003001,2001,0001003001,400+ 100Output ↓

19. 19 of 40 © 2014 Pearson Education, Inc. TABLE 24.4 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

20. 20 of 40 © 2014 Pearson Education, Inc. 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.

21. 21 of 40 © 2014 Pearson Education, Inc. federal budget The budget of the federal government. The Federal Budget Because fiscal policy is the manipulation of items in the federal budget, that budget is relevant to our study of macroeconomics. An enormously complicated document up to thousands of pages each year, the federal budget lists in detail all the things the government plans to spend money on and all the sources of government revenues for the coming year. It is the product of a complex interplay of social, political, and economic forces.

22. 22 of 40 © 2014 Pearson Education, Inc. TABLE 24.5 Federal Government Receipts and Expenditures, 2012 (Billions of Dollars) AmountPercentage of Total Current receipts Personal income taxes1,137.842.5 Excise taxes and customs duties116.14.3 Corporate income taxes373.714.0 Taxes from the rest of the world17.30.6 Contributions for social insurance934.835.0 Interest receipts and rents and royalties53.42.0 Current transfer receipts from business and persons59.22.2 Current surplus of government enterprises − 17.8 − 0.7 Total2,674.5100.0 Current expenditures Consumption expenditures1,059.628.2 Transfer payments to persons1,773.247.2 Transfer payments to the rest of the world76.42.0 Grants-in-aid to state and local governments468.012.5 Interest payments318.58.5 Subsidies60.41.6 Total3,756.1100.0 Net federal government saving–surplus (+) or deficit (−) (Total current receipts − Total current expenditures) − 1,081.6 The Budget in 2012 federal surplus (+) or deficit (−) Federal government receipts minus expenditures.

23. 23 of 40 © 2014 Pearson Education, Inc.  FIGURE 24.4 Federal Personal Income Taxes as a Percentage of Taxable Income, 1993 I–2012 IV Fiscal Policy Since 1993: The Clinton, Bush, and Obama Administrations

24. 24 of 40 © 2014 Pearson Education, Inc.  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–2012 IV

25. 25 of 40 © 2014 Pearson Education, Inc.  FIGURE 24.6 The Federal Government Surplus (+) or Deficit (−) as a Percentage of GDP, 1993 I–2012 IV

26. 26 of 40 © 2014 Pearson Education, Inc. E C O N O M I C S I N P R A C T I C E The U.S. Congress Fights about the Budget In January 2013, Congress signed the American Tax Relief Act (ATRA), which retained many of the earlier Bush tax cuts, while modifying others. But the specter of automatic spending cuts remained. In the spring of 2013, arguments about the shape of the 2014 budget were raging, as members of the House commented on a budget proposal of Paul Ryan, Republican Congressman from Wisconsin. Representative Eddie Bernice Johnson of Texas, a Democrat, had this to say about Congressman Ryan’s bill: “This budget would not only jeopardize seniors, families and the most vulnerable in our society, it would also destroy jobs and put our nation’s economic recovery at risk.” The Congress heard a different view from Andy Barr, a new Republican Congressman from Kentucky: “Families and small businesses should be able to keep more of their hard-earned income instead of having it wasted by Washington bureaucrats.” THINKING PRACTICALLY 1.How would you describe the views of the two people quoted on the benefits of government spending?

27. 27 of 40 © 2014 Pearson Education, Inc. 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 Government Debt

28. 28 of 40 © 2014 Pearson Education, Inc.  FIGURE 24.7 The Federal Government Debt as a Percentage of GDP, 1993 I–2012 IV

29. 29 of 40 © 2014 Pearson Education, Inc. E C O N O M I C S I N P R A C T I C E The Debt Clock Next time you are in New York City, wander by West 44 th Street and the Avenue of the Americas. Located on an outside wall is a U.S. Debt Clock, mounted by Seymour Durst, a N.Y. real estate developer. Rather than showing us the passage of time, as would a conventional clock, this clock shows us the mounting of the U.S. debt. Durst was an early worrier about the debt! Needless to say, it sped up during the Obama administration. See Figure 24.7. THINKING PRACTICALLY 1.For a few years beginning in 2000, the clock was stopped and covered up. Can you guess why based on the data you have seen in this chapter?

30. 30 of 40 © 2014 Pearson Education, Inc. 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.

31. 31 of 40 © 2014 Pearson Education, Inc. 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. Full-Employment Budget

32. 32 of 40 © 2014 Pearson Education, Inc. 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.

33. 33 of 40 © 2014 Pearson Education, Inc. 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 Disposable income Y d ≡ Y − T AE ≡ C + I + G Government budget deficit ≡ G − T Equilibrium in an economy with a government: Y = C + I + G Saving/investment approach to equilibrium in an economy with a government: S + T = I + G 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

34. 34 of 40 © 2014 Pearson Education, Inc. 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: 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):

35. 35 of 40 © 2014 Pearson Education, Inc. It is easy to show formally that the balanced-budget multiplier = 1. initial increase in spending: − initial decrease in spending: = net initial increase in spending In a balanced-budget increase, ∆G = ∆T; so in the above equation for the net initial increase in spending we can substitute ∆G for ∆T. ∆G − ∆G (MPC) = ∆G (1 − MPC) The Balanced-Budget Multiplier

36. 36 of 40 © 2014 Pearson Education, Inc. 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: Thus, the final total increase in the equilibrium level of Y is just equal to the initial balanced increase in G and T.

37. 37 of 40 © 2014 Pearson Education, Inc.  FIGURE 24B.1 The Tax Function CHAPTER 24 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.

38. 38 of 40 © 2014 Pearson Education, Inc. 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

39. 39 of 40 © 2014 Pearson Education, Inc. The Government Spending and Tax Multipliers Algebraically We know that Y = C + I + G. Through substitution we get Solving for Y:

40. 40 of 40 © 2014 Pearson Education, Inc. 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