1. CHAPTER OUTLINE Chapter 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 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 Appendix A: Deriving the Fiscal Policy Multipliers Appendix B: The Case in Which Tax Revenues Depend on Income

2. 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.

3. 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 )

4.  FIGURE 9.1 Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income: A little more complicated

5. The disposable income (Y d ) of households must end up as either consumption (C) or saving (S). Thus, Because disposable income is Y d ≡ Y − 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).

6. 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 Which can also be written as the difference between what the government collects in taxes and what it spends in a given period: T − G: budget deficit ≡ T − G

7. 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

8. The government can affect investment behavior through its tax treatment of depreciation and other tax policies. Planned investment depends on the interest rate. For purposes of this chapter, as in chapter 8, we assume the interest rate and planned investment ( I ) are fixed.. - I is assumed to be autonomous. Planned Investment ( I )

9. We assume G is fixed, G is autonomous. We initially assume T is fixed, T is autonomous. Government (G) and Taxes (T)

10. Y = C + I + G TABLE 9.1 Finding Equilibrium for I = 100, G = 100, and T = 100 All Figures in Billions of Dollars (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.  FIGURE 9.2 Finding Equilibrium Output/Income Graphically Because G and I are both fixed at 100, the aggregate expenditure function is the consumption function displaced upward by I + G = 200. Equilibrium occurs at Y = C + I + G = 900.

12. The Determination of Equilibrium Output (Income) The Math Equilibrium condition: Y = C + I + G The sectors: C = 100 +.75(Y – T) I = 100 T = 100 G = 100 Substitute the sector information into equilibrium condition: Y = 100+.75(Y – 100) + 100 + 100.25Y = 100 – 75 + 100 + 100.25Y = 225 Y = 225/.25 Y = 900

13. 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 = C + I + G and by definition Y = C + S + T. Therefore, at equilibrium: Y = AE C + S + T = C + I + G Subtracting C from both sides leaves: S + T = I + G The Saving/Investment Approach to Equilibrium

14. At this point, we are assuming that the government controls G and T. In this section, we will examine three multipliers: Government spending multiplier Tax multiplier Balanced-budget multiplier Fiscal Policy at Work: Multiplier Effects

15. government spending multiplier The ratio of the change in the equilibrium level of output to a change in government spending = Same as the investment spending multiplier

16. TABLE 9.2 Finding Equilibrium after a Government Spending Increase of 50 (G Has Increased from 100 in Table 9.1 to 150 Here) MPC = 0.75 (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 ↓

17.  FIGURE 9.3 The Government Spending Multiplier MPC = 0.75 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.

18. THE TAX MULTIPLIER tax multiplier The ratio of change in the equilibrium level of output to a change in taxes = The multiplier for a change in taxes is not the same as the multiplier for a change in government spending. FISCAL POLICY AT WORK: MULTIPLIER EFFECTS

20. 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

21. 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 500300200250100300650−150Output ↑ 700300400 100300800−100Output ↑ 900300600550100300950−50Output ↑ 1,1003008007001003001,1000Equilibrium 1,3003001,0008501003001,250+ 50Output ↓ 1,5003001,2001,0001003001,400+ 100Output ↓

22. 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

23. 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.

24. The Federal Budget Receipts and Expenditures of the Federal Government. Also referred to as Revenues and Outlays of the Federal Government federal budget surplus (+) or deficit (−): Federal government receipts minus expenditures.

25. TABLE 9.5 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.

26. TABLE 9.5 Federal Government Receipts and Expenditures, 2012 (Billions of Dollars) AmountPercentage of Total Current receipts Personal income taxes1,54147.4 Excise taxes and customs duties Corporate income taxes34410.6 Taxes from the rest of the world Contributions for social insurance1,06532.7 Interest receipts and rents and royalties Current transfer receipts from business and persons Other2999.2 Total3,249100.0 Current expenditures Mandatory2,29970.0 Discretionary1,16524.0 Interest payments2236.0 Subsidies Total3,687100.0 Net federal government saving: surplus (+) or deficit (−) (Total current receipts − Total current expenditures) − 438 The Budget in 2015 – selected items federal surplus (+) or deficit (−) Federal government receipts minus expenditures.

27. Federal Outlays and Revenue, 1965–2025: Expressed as percent of GDP 27

28. Budget Surplus or Deficit:1959–2015, Expressed as percent of GDP 28 Deficits increase during recessions and decrease during expansions

29. 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

30. Automatic Stabilizers In a recession – budget deficit automatically increases because transfers payments rise and tax revenue falls (or the budget surplus decreases) In an expansion – budget deficit automatically decreases because transfers decrease and tax revenue rises (or the budget surplus increases) 30

31. Deficits and the National Debt Budget deficits need to be financed – increase the public’s bond holdings –increase the national debt Budget surpluses – decrease the public’s bond holdings – decrease the national debt Debt ratio – national debt as a percentage of GDP 31

32. The U.S. Debt Ratio Reagan Clinton Bush Obama Debt as a percentage of GDP soared during World War II, then fell steadily for several decades. It rose during the 1980s, fell in the 1990s, and then surged from 2009–2011 due to recession and fiscal stimulus policies.

33. Federal Government Debt - National Debt The total national debt – what the government owes – In Dec 2015, it was approaching $18.9 trillion – Amount the government owed to the public was $13.6 trillion, privately held. This has a macroeconomic impact – Amount that one government agency owed to another was about $5.3 trillion) No macroeconomic impact at all 33

34. Major Foreign Holders of US Gov’t Debt 34 http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt

35. 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

36. 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

37. 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):

38. The Multipliers

39.  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. 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

41. The Government Spending and Tax Multipliers Algebraically We know that Y = C + I + G. Through substitution we get Solving for Y:

42. 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