21 © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair The Government and Fiscal Policy Appendix A: Deriving the Fiscal Policy Multipliers Appendix B: The Case in Which Tax Revenues Depend on Income Prepared by: Fernando Quijano and Yvonn Quijano

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 2 of 35 Government in the Economy Nothing arouses as much controversy as the role of government in the economy. Government can affect the macroeconomy in two ways: Fiscal policy is the manipulation of government spending and taxation. Monetary policy refers to the behavior of the Federal Reserve regarding the nation’s money supply.

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 3 of 35 Government in the Economy Discretionary fiscal policy refers to deliberate changes in taxes or spending. The government can not control certain aspects of the economy related to fiscal policy. For example: The government can control tax rates but not tax revenue. Tax revenue depends on household income and the size of corporate profits. Government spending depends on government decisions and the state of the economy.

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 4 of 35 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. Disposable, or after-tax, income (Y d ) equals total income minus taxes.

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 5 of 35 Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 6 of 35 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: And aggregate expenditure (AE) equals:

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 7 of 35 The Budget Deficit A government’s 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.

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 8 of 35 Adding Taxes to the Consumption Function The aggregate consumption function is now a function of disposable, or after-tax, income.

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 9 of 35 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   150 Output  100 Output  50 Output Equilibrium 1, , , Output 9 1, ,2001, , Output 9 1, ,4001, , Output 9

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 10 of 35 Finding Equilibrium Output/Income Graphically

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 11 of 35 The Leakages/Injections Approach 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,

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 12 of 35 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.

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 13 of 35 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   200 Output  150 Output  100 Output  50 Output 8 1, , ,1000Equilibrium 1, ,2001, , Output 9

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 14 of 35 The Government Spending Multiplier

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 15 of 35 The Tax Multiplier A tax cut increases disposable income, and leads to added consumption spending. Income will increase by a multiple of the decrease in taxes. A tax cut has no direct impact on spending. The multiplier for a change in taxes is smaller than the multiplier for a change in government spending.

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 16 of 35 The Tax Multiplier

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 17 of 35 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.

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 18 of 35 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  150 Output  100 Output  50 Output 8 1, ,1000Equilibrium 1, , , Output 9 1, ,2001, , Output 9

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 19 of 35 Fiscal Policy Multipliers Summary of Fiscal Policy Multipliers POLICY STIMULUSMULTIPLIER FINAL IMPACT ON EQUILIBRIUM Y Government- spending multiplier Increase or decrease in the level of government purchases: Tax multiplierIncrease 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

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 20 of 35 The Federal Budget The federal budget is the budget of the federal government. The difference between the federal government’s receipts and its expenditures is the federal surplus (+) or deficit (-).

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 21 of 35 The Federal Budget Federal Government Receipts and Expenditures, 2000 (Billions of Dollars) AMOUNT PERCENTAGE OF TOTAL Receipts Personal taxes1, Corporate taxes Indirect business taxes Contributions for social insurance Total2, 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.

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 22 of 35 The Federal Government Surplus (+) or Deficit (-) as a Percentage of GDP, 1970 I  2003 II

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 23 of 35 The Debt The federal debt is the total amount owed by the federal government. The debt is the sum of all accumulated deficits minus surpluses over time. Some of the federal debt is held by the U.S. government itself and some by private individuals. The privately held federal debt is the private (non- government-owned) portion of the federal debt.

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 24 of 35 The Federal Government Debt as a Percentage of GDP, 1970 I  2003 II The percentage began to fall in the mid 1990s.

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 25 of 35 The Economy’s Influence on the Government Budget 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.

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 26 of 35 The Economy’s 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.

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 27 of 35 The Economy’s Influence on the Government Budget The full-employment budget is what the federal budget would be if the economy were producing at a full-employment level of output.

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 28 of 35 The Economy’s Influence on the Government Budget 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.

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 29 of 35 Review Terms and Concepts automatic stabilizers automatic stabilizers balanced-budget multiplier balanced-budget multiplier budget deficit budget deficit cyclical deficit cyclical deficit discretionary fiscal policy discretionary fiscal policy disposable, or after-tax, income disposable, or after-tax, income federal budget federal budget federal debt federal debt federal surplus (+) or deficit (-) federal surplus (+) or deficit (-) fiscal drag fiscal drag fiscal policy fiscal policy full-employment budget full-employment budget government spending multiplier government spending multiplier monetary policy monetary policy net taxes net taxes privately held federal debt privately held federal debt structural deficit structural deficit tax multiplier tax multiplier

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 30 of 35 Appendix A: Deriving the Fiscal Policy Multipliers The government spending and tax multipliers algebraically:

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 31 of 35 Appendix A: Deriving the Fiscal Policy Multipliers The balanced-budget multiplier is found by combining the effects of government spending and taxes: The balanced-budget multiplier equals one. An increase in G and T by one dollar each causes a one-dollar increase in Y. increase in spending: - decrease in spending: = net increase in spending

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 32 of 35 Appendix B: The Case In Which Tax Revenues Depend on Income

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 33 of 35 Appendix B: The Case In Which Tax Revenues Depend on Income

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 34 of 35 Appendix B: The Case In Which Tax Revenues Depend on Income The Government Spending and Tax Multipliers Algebraically:

C H A P T E R 21: The Government and Fiscal Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 35 of 35 Appendix B: The Case In Which Tax Revenues Depend on Income The government spending and tax multipliers when taxes are a function of income are derived as follows: