1. CASE  FAIR  OSTER MACROECONOMICS PRINCIPLES OF
E L E V E N T H E D I T I O N
CASE  FAIR  OSTER
Prepared by: Fernando Quijano w/She1llyoTf e4f0ft
PEARSON

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3. The Government and Fiscal Policy9
The Government and
Fiscal Policy
CHAPTER OUTLINE
Government in the Economy
Government Purchases (G), Net Taxes (T), and Disposable Income (Yd)
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
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4. fiscal policy The government’s spending and taxing policies.
monetary policy The behavior of the Federal Reserve concerning the nation’s money supply.
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5. Fiscal policy is generally divided into three categories:
policies concerning government purchases of goods and services,
policies concerning taxes,
policies concerning transfer payments (such as unemployment compensation, Social Security benefits, welfare payments, and veterans’ benefits) to households.
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6. Government in the Economy
discretionary fiscal policy ةيريدقتلا ةيلاملا ةسايسلاChanges in taxes or spending that are the result of deliberate changes in government policy.
Government Purchases (G), Net Taxes (T), and Disposable Income (Yd)
Add the rule of government to chapter 8
net taxes (T) Taxes paid by firms and households to the government minus transfer payments made to households by the government(such as unemployment compensation, Social Security benefits, welfare payments,
and veterans’ benefits)
disposable, or after-tax, income (Yd) Total income minus net taxes: Y − T.
disposable income ≡ total income − net taxes
Yd ≡ Y − T
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7.  FIGURE 9.1 Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of
Income
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8. AE  C  I  G Y  C  S  T Y  T  C  S Yd  C  S
The disposable income (Yd) of households must end up as either consumption
(C) or saving (S). Thus,
Yd  C  S
Because disposable income is aggregate income (Y) minus net taxes (T), we
can write another identity:
Y  T  C  S
By adding T to both sides:
Y  C  S  T
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).
AE  C  I  G
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9. If G exceeds T, the government must borrow from the
public to finance the deficit. It does so
by selling a part of
Treasury bonds and bills. In this case,
household saving (S) goes to the government.
So, mean that some S goes to firms to
finance
investment projects and some goes to the government to finance its deficit. If G is less than T, which means that the government is spending less than it is collecting in taxes, the government is running a surplus. A budget surplus is simply a negative budget deficit.
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10. C = a + bYd C = a + b(Y − T) budget deficit ≡ G − T
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
Adding Taxes to the Consumption Function
To modify our aggregate consumption function to incorporate disposable income instead of before-tax income, instead of C = a + bY, we write
C = a + bYd or
C = a + b(Y − T)
Our consumption function now has consumption depending on disposable
income instead of before-tax income.
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11. Planned Investment
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.
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12. The Determination of Equilibrium Output (Income)
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)
Planned
Unplanned
Output
Net
Disposable
Consumption
Saving
Investment
Government
Aggregate
Inventory
Adjustment
(Income)
Taxes
Income
Spending S
Purchases
Expenditure
Change
to Disequi- Y T
Yd ≡Y −T
C = Yd
Yd – C I G
C + I + G
Y − (C + I + G)
librium
300
100
200
250
− 50
450
− 150
Output ↑
500
400
600
− 100
700
550 50
750
900
800
Equilibrium
1,100
1,000
850
150
1,050
+ 50
Output ↓
1,300
1,200
+ 100
1,500
1,400
1,150
1,350
+ 150
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13.  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.
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14. saving/investment approach to equilibrium:
The Saving/Investment Approach to Equilibrium
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
Note that equilibrium does not require that G = T (a balanced
government budget) or that S = I.
It is only necessary that the sum of S and T equals the sum of I and G.
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15. Fiscal Policy at Work: Multiplier Effects
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
The Government Spending Multiplier
1 1
government spending multiplier  
MPS 1 MPC
government spending multiplier The ratio of the change in the equilibrium
level of output to a change in government spending.
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16. its impact on equilibrium output.
Example:
If an acceptable unemployment rate can be achieved only if aggregate output increases to 1,100 instead of 900, and taxes must remain constant??
1.To increase spending without raising Tax, Government must borrow 2.Ignore the deficit
Output rises, income rises, leads to generate employment, some of the new workers income gets spent.
Planned spending will be greater than output, then firms will raise
output.
This is the impact of the Multiplier
A dollar of extra spending from either G or I is identical with respect to
its impact on equilibrium output.
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17. 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)
Unplanned
Planned
Inventory
Output
Net
Disposable
Consumption
Saving
Investment
Government
Aggregate
Change
Adjustment
(Income)
Taxes
Income
Spending S
Purchases
Expenditure
Y − (C + I + to Y T
Yd ≡Y −T
C = Yd
Yd – C I G
C + I + G G)
Disequilibrium
300
100
200
250
 50
150
500
 200
Output ↑
400
650
 150
700
600
550 50
800
 100
900
950
1,100
1,000
850
Equilibrium
1,300
1,200
1,250
+ 50
Output ↓
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18. Increasing government spending by 50 shifts the AE function up by 50.
 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.
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19. A tax cut increases disposable income, which is likely to lead
Tax multiplier:
Is The ratio of change in the equilibrium level of output to a change in taxes.
A tax cut increases disposable income, which is likely to lead
to added consumption spending.
Planned aggregate expenditure will increase
then will lead to inventories being lower than planned, which
will lead to a rise in output.
When output rises, more workers will be employed and more income will be generated,
Thus, income will increase by a multiple of the decrease in taxes,
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20. Example:
assume that the government decides to cut taxes by $1. By how much would spending increase? We already know the answer. The marginal propensity to consume (MPC) tells us how much consumption spending changes when disposable
income changes. In the example running through this chapter, the marginal propensity to consume out of disposable income is .75. This means that if households’ after-tax incomes rise by $1.00, they will increase their consumption not by the full $1.00, but by only $0.75
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21.     T   MPC   MPS   MPS   MPS  1 
The Tax Multiplier 1 
 Y  (initial increase in aggregate expenditure)  
 MPS 
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: 1
Y  (  T  MPC)  
  T   MPC 
 MPS   MPS 
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:
 
MPC
MPS
tax multiplier  
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22. It is The balanced Budget Muitiplier
what if the government decides to pay for its extra spending by increasing taxes by the same amount? The government’s budget deficit would not change because the increase in expenditures would be matched by an increase in tax income.
It is The balanced Budget Muitiplier
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23. analysis that an increase in G of 40,
Example:
If the government spending increase of $40 billion, We know from the preceding
analysis that an increase in G of 40,
with taxes (T) held constant, should increase the equilibrium level of income by 40 the government spending multiplier.
= The equilibrium level of income should rise by 160 (40 * 4).
If we finance the 40 increase in government spending with an equal increase in taxes then: There are two initial effects.
government spending rises by 40. This effect is direct, immediate, and positive.
The tax increase has a negative impact on overall spending in the economy, The final impact of a tax increase on aggregate expenditure depends on how households respond to it.( MPC)
C. Adding 40 Tax, then consumption falls by 30 (40 * .75)
d. The net result in the beginning is that government spending rises by 40 and consumption spending falls by 30.Aggregate expenditure increases by 10 right after the simultaneous balanced-budget increases in G and T.
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24. by using the government spending multiplier, a 40 increase in G would raise output at equilibrium by (40 the government spending multiplier of 4). By using the tax multiplier, we know that a tax hike of 40 will reduce the equilibrium level of output by 120 (40 the tax multiplier, -3). The net effect is 160 minus 120, or 40
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25. The Balanced-Budget Multiplier
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.
balanced-budget multiplier  1
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26. G and T Have Increased from 100 in Table 9.1 to 300 Here)
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)
Planned
Unplanned
Output
Net
Disposable
Consumption
Investment
Government
Aggregate
Inventory
Adjustment
(Income)
Taxes
Income
Spending
Purchases
Expenditure
Change to Y T
Yd ≡Y − T
C = Yd I G
C + I + G
Y − (C + I + G)
Disequilibrium
500
300
200
250
100
650
−150
Output ↑
700
400
800
−100
900
600
550
950
−50
1,100
Equilibrium
1,300
1,000
850
1,250
+ 50
Output ↓
1,500
1,200
1,400
+ 100
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27. Increase or decrease in the
TABLE 9.4 Summary of Fiscal Policy Multipliers
Final Impact on Equilibrium Y
Policy Stimulus Multiplier
Government spending multiplier
Increase or decrease in the level of government purchases: ∆G 1 1
G 
MPS
MPS
Tax multiplier
Increase or decrease in the
level of net taxes: ∆T
MPC
MPC
T 
MPS
MPS
Balanced- budget multiplier
Simultaneous balanced-budget increase or decrease in the level of government purchases and
net taxes: ∆G = ∆T
 G 1
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28. 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.
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29. The Federal Budget
Because fiscal policy is the manipulation of items in the federal budget, that budget is relevant to our study of macroeconomics.
federal budget The budget of the federal government.
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.
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30. The Budget in 2012
TABLE 9.5 Federal Government Receipts and Expenditures, 2012 (Billions of Dollars)
Amount Percentage of Total
Current receipts
Personal income taxes
1,137.8
42.5
Excise taxes and customs duties
116.1
4.3
Corporate income taxes
373.7
14.0
Taxes from the rest of the world
17.3
0.6
Contributions for social insurance
934.8
35.0
Interest receipts and rents and royalties
53.4
2.0
Current transfer receipts from business and persons
59.2
2.2
Current surplus of government enterprises
− 17.8
− 0.7
Total
2,674.5
100.0
Current expenditures
Consumption expenditures
1,059.6
28.2
Transfer payments to persons
1,773.2
47.2
Transfer payments to the rest of the world
76.4
2.0
Grants-in-aid to state and local governments
468.0
12.5
Interest payments
318.5
8.5
Subsidies
60.4
1.6
Total
3,756.1
100.0
Net federal government saving–surplus (+) or deficit (−)
(Total current receipts − Total current expenditures)
− 1,081.6
federal surplus (+) or deficit (−) Federal government receipts minus expenditures.
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31. Fiscal Policy Since 1993: The Clinton, Bush, and Obama Administrations
 FIGURE 9.4 Federal Personal Income Taxes as a Percentage of Taxable Income, 1993 I–2012 IV
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32.  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–2012 IV
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33.  FIGURE 9.6 The Federal Government Surplus (+) or Deficit (−) as a Percentage of GDP,
1993 I–2012 IV
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34. The U.S. Congress Fights about the Budget
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?
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35. The Federal Government Debt
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.
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36.  FIGURE 9.7 The Federal Government Debt as a Percentage of GDP, 1993 I–2012 IV
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37. 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 44th 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 9.7.
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?
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38. *Automatic Stabilizers and Destabilizers
Tax revenues thus depend on the state of the economy even when the government does not change tax rates. Either Income Tax or Corporate profit Tax *
When the economy goes into a recession, tax revenues will fall, even if rates remain constant, and when the economy picks up, so will tax revenues. As a result, deficits fall in expansions and rise in recessions, other things being equal.
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39. Some items on the expenditure side of the government budget also automatically change as the economy changes.
If the economy declines, unemployment increases, which leads to an increase in unemployment benefits. Welfare payments, food stamp allotments, and similar transfer payments also increase in recessions and decrease in expansions.
These automatic changes in government revenues and expenditures are called automatic stabilizers. They help stabilize the economy. In recessions taxes fall and expenditures rise, which create positive effects on the economy, and in expansions the opposite happens. The government does not have to change any laws for this to happen.
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40. Destabilizers: Inflation
transfer payments increase as inflation increases. So, Government spending increases as inflation increases, which further fuels the expansion, which is destabilizing.
If inflation decreases in a recession, there is an automatic decrease in government spending, which makes the recession worse.
Government spending on interest payments thus tends to rise in expansions and fall in contractions, which, other things being equal, is destabilizing
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41. The Economy’s Influence on the Government Budget
Automatic Stabilizers and Destabilizers
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.
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.
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.
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42. Full-Employment Budget
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.
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43. 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.
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44. R E V I E W T E R M S A N D C O N C E P T S
automatic destabilizers automatic stabilizers balanced-budget multiplier budget deficit
cyclical deficit discretionary fiscal policy
disposable, or after-tax, income (Yd)
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 Yd ≡ 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
MPS 1 MPC
1 1  
 MPC 
7. Tax multiplier ≡
 MPS 
 
8. Balanced-budget multiplier ≡ 1
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45. 1 b Y  a  bY  bT  I  G Y  bY  a  I  G  bT 1 Y 
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:
C  a  b(Y  T)
The equilibrium condition is
Y  C  I  G
By substituting for C, we get
Y  a  b(Y  T)  I  G
Y  a  bY  bT  I  G
This equation can be rearranged to yield
Y  bY  a  I  G  bT
Y(1 b)  a  I  G  bT
Now solve for Y by dividing through by (1 − b): 1
Y 
(a  I  G  bT )
1 b
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46. The Balanced-Budget Multiplier
It is easy to show formally that the balanced-budget multiplier = 1.
initial increase in spending:
− initial decrease in spending: G
C  T (MPC)
= net initial increase in spending
G  T (MPC)
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)
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47.   G  MPS   MPS  1 Y  G(MPS)    ∆G (MPS) 1   
Because MPS = (1 − MPC), the net initial increase in spending is:
∆G (MPS) 1 
We can now apply the expenditure multiplier 
to this net initial
 
 MPS 
increase in spending: 1
Y  G(MPS) 
  G
 MPS   
Thus, the final total increase in the equilibrium level of Y is just equal to the initial balanced increase in G and T.
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48. CHAPTER 9 APPENDIX B Yd  Y T Yd  Y  (200 1/ 3Y )
The Case in Which Tax Revenues Depend on Income
 FIGURE 9B.1 The Tax Function
This graph shows net taxes (taxes minus transfer payments) as a function of aggregate income.
Yd  Y T
Yd  Y  (200 1/ 3Y )
Yd  Y  200 1/ 3Y
C  100  .75Yd
C 100 .75(Y  200 1/ 3Y )
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49. Y  C  I  G Y  100  .75(Y  200 1/ 3Y ) 100 100 I G C
 FIGURE 9B.2 Different Tax Systems
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.
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50. 1 Y  (a  I  G  bT ) 1  b  bt Y  a  bY  bT  btY  I  G C
The Government Spending and Tax Multipliers Algebraically
C  a  b(Y  T)
C  a  b(Y T0  tY )
C  a  bY  bT0  btY
We know that Y = C + I + G. Through substitution we get
Y  a  bY  bT  btY  I  G C
Solving for Y: 1
Y 
(a  I  G  bT )
1  b  bt
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51. This means that a $1 increase in G or I (holding a and T0 constant) will increase the equilibrium level of Y by 1
1 b  bt
Holding a, I, and G constant, a fixed or lump-sum tax cut (a cut in T0) will
increase the equilibrium level of income by b
1 b  bt
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