© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 20 Prepared by: Fernando Quijano and Yvonn Quijano The Government and Fiscal Policy

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Government in the Economy Nothing arouses as much controversy as the role of 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.Government can affect the macroeconomy through two policy channels: fiscal policy and monetary policy. Fiscal policy is the manipulation of government spending and taxation. Fiscal policy is the manipulation of government spending and taxation. Monetary policy refers to the behavior of the Federal Reserve regarding the nations money supply. Monetary policy refers to the behavior of the Federal Reserve regarding the nations money supply.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl 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.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.Discretionary fiscal policy refers to changes in taxes or spending that are the result of deliberate changes in government policy.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Net Taxes (T), and Disposable Income (Y d ) Net taxes are taxes paid by firms and households to the government minus transfer payments made to households by the government.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 (Y d ) equals total income minus taxes.Disposable, or after-tax, income (Y d ) equals total income minus taxes.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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:When government enters the picture, the aggregate income identity gets cut into three pieces: And aggregate expenditure (AE) equals:And aggregate expenditure (AE) equals:

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Budget Deficit A governments budget deficit is the difference between what it spends (G) and what it collects in taxes (T) in a given period:A governments budget deficit is the difference between what it spends (G) and what it collects in taxes (T) in a given period: 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.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.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Adding Taxes to the Consumption Function With taxes a part of the picture, the aggregate consumption function is a function of disposable, or after-tax, income.With taxes a part of the picture, the aggregate consumption function is a function of disposable, or after-tax, income.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Equilibrium Output: Y = C + I + G 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 = 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 Output Output Output Equilibrium 1, , , Output 9 1, ,2001, , Output 9 1, ,4001, , Output 9

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Finding Equilibrium Output/Income Graphically

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Leakages/Injections Approach Taxes (T) are a leakage from the flow of income. Saving (S) is also a leakage.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,In equilibrium, aggregate output (income) (Y) equals planned aggregate expenditure (AE), and leakages (S + T) must equal planned injections (I + G). Algebraically,

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.The government spending multiplier is the ratio of the change in the equilibrium level of output to a change in government spending.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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)(4)(5)(6)(7)(8)(9)(10) OUTPUT (INCOME) Y NET TAXES T DISPOSABLE INCOME Y d / Y T CONSUMPTION SPENDING (C = 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 Output Output Output Output 8 1, , ,1000Equilibrium 1, ,2001, , Output 9

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Government Spending Multiplier

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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.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.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Tax Multiplier 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.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.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl 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.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.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl 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 Y d / Y T CONSUMPTION SPENDING (C = 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 Output Output Output 8 1, ,1000Equilibrium 1, , , Output 9 1, ,2001, , Output 9

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Fiscal Policy Multipliers Summary of Fiscal Policy Multipliers POLICY STIMULUS MULTIPLIER FINAL IMPACT ON EQUILIBRIUM Y Government- spending multiplier Increase or decrease in the level of government purchases: Tax multiplier Increase or decrease in the level of net taxes: Balanced- budget multiplier Simultaneous balanced-budget increase or decrease in the level of government purchases and net taxes: 1

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl 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.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:With imports and exports, the equilibrium condition for the economy is: 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.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.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl 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 Total1, Current Expenditures Consumption Transfer payments Grants-in-aid to state and local governments Net interest payments Net subsidies of government enterprises Total1, Current Surplus (+) or deficit ( ) (Receipts Current Expenditures) Source: U.S. Department of Commerce, Bureau of Economic Analysis.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Federal Government Surplus/Deficit as a Percentage of GDP, 1970 I 2000 IV

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Federal Government Debt as a Percentage of GDP, 1970 I 2000 IV The percentage began to fall in the mid 1990s.The percentage began to fall in the mid 1990s.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Economys Influence on the Government Budget Tax revenues depend on the state of the economy.Tax revenues depend on the state of the economy. Some government expenditures 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.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.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Economys 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.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.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Economys Influence on the Government Budget The full-employment budget is a benchmark for evaluating fiscal policy.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 full- employment level of output.The full-employment budget is what the federal budget would be if the economy were producing at a full- employment level of output.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Economys Influence on the Government Budget The cyclical deficit is the deficit that occurs because of a downturn in the business cycle.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.The structural deficit is the deficit that remains at full employment.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl 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:The government spending and tax multipliers when taxes are a function of income are derived as follows: multipliervalue of autonomous expenditures

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl 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:If we combine the effects of the government spending multiplier and the tax multiplier, we obtain: and Tax multiplier Multiplier of government spending In words, a simultaneous increase in government spending by $1 and lump-sum taxes by $1 will increase equilibrium income by $1.In words, a simultaneous increase in government spending by $1 and lump-sum taxes by $1 will increase equilibrium income by $1. then:

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Appendix B: The government spending and tax multipliers The government spending and tax multipliers are derived algebraically as follows:The government spending and tax multipliers are derived algebraically as follows: multipliervalue of autonomous expenditures