PowerPoint Lectures for Principles of Macroeconomics, 9e

PowerPoint Lectures for Principles of Macroeconomics, 9e
By Karl E. Case, Ray C. Fair & Sharon M. Oster ; ;

The Government and Fiscal Policy
Prepared by: Fernando & Yvonn Quijano

9 The Government and Fiscal Policy
PART III THE CORE OF MACROECONOMIC THEORY 9 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 2007 Fiscal Policy Since 1993: The Clinton and Bush Administrations The Federal Government Debt The Economy’s Influence on the Government Budget Tax Revenues Depend on the State of the Economy Some Government Expenditures Depend on the State of the Economy Automatic Stabilizers Fiscal Drag Full-Employment Budget Looking Ahead Appendix A: Deriving the Fiscal Policy Multipliers Appendix B: The Case in Which Tax Revenues Depend on Income

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.

disposable income ≡ total income − net taxes
Government in the Economy discretionary fiscal policy Changes in taxes or spending that are the result of deliberate changes in government policy. Government Purchases (G), Net Taxes (T), and Disposable Income (Yd) 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 (Yd) Total income minus net taxes: Y - T. disposable income ≡ total income − net taxes Yd ≡ Y − T

Government in the Economy
Government Purchases (G), Net Taxes (T), and Disposable Income (Yd)  FIGURE 9.1 Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income

Government Purchases (G), Net Taxes (T), and Disposable Income (Yd) When government enters the picture, the aggregate income identity gets cut into three pieces: And aggregate expenditure (AE) equals:

Government Purchases (G), Net Taxes (T), and Disposable Income (Yd) 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

Government Purchases (G), Net Taxes (T), and Disposable Income (Yd) 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.

Government Purchases (G), Net Taxes (T), and Disposable Income (Yd) Planned Investment The government can affect investment behavior through its tax treatment of depreciation and other tax policies.

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) Output (Income) Y Net Taxes T Disposable Income Yd / Y - T Consumption Spending (C = Yd) Saving S (Yd – 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 300 100 200 250 - 50 450 - 150 Output8 500 400 600 - 100 700 550 50 750 900 800 Equilibrium 1,100 1,000 850 150 1,050 + 50 Output9 1,300 1,200 + 100 1,500 1,400 1,150 1,350 + 150

The Determination of Equilibrium Output (Income)  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.

saving/investment approach to equilibrium:
Government in the Economy The Determination of Equilibrium Output (Income) 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

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 government spending multiplier The ratio of the change in the equilibrium level of output to a change in government spending.

The Government Spending Multiplier 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) Output (Income) Y Net Taxes T Disposable Income Yd / Y - T Consumption Spending (C = Yd) Saving S (Yd – C) Planned Investment Spending I Government Purchases G Planned Aggregate Expenditure C + I + G Unplanned Inventory Change Y - (C + I + G) Adjustment To Disequilibrium 300 100 200 250 - 50 150 500 - 200 Output8 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

The Government Spending Multiplier  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.

The Tax Multiplier tax multiplier The ratio of change in the equilibrium level of output to a change in taxes.

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.

The Balanced-Budget Multiplier 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 Yd / Y - T Consumption Spending (C = Yd) Planned Investment Spending I Government Purchases G Planned Aggregate Expenditure C + I + G Unplanned Inventory Change Y - (C + I + G) Adjustment To Disequilibrium 500 300 200 250 100 650 - 150 Output8 700 400 800 - 100 900 600 550 950 - 50 1,100 Equilibrium 1,300 1,000 850 1,250 + 50 Output9 1,500 1,200 1,400 + 100

Final Impact On Equilibrium Y
Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier TABLE 9.4 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: ∆G Tax multiplier Increase 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

The Federal Budget federal budget The budget of the federal government. The “budget” is really three different budgets. First, it is a political document that dispenses favors to certain groups or regions and places burdens on others. Second, it is a reflection of goals the government wants to achieve. Third, the budget may be an embodiment of some beliefs about how (if at all) the government should manage the macroeconomy.

The Federal Budget The Budget in 2007
TABLE 9.5 Federal Government Receipts and Expenditures, 2007 (Billions of Dollars) Amount Percentage Of Total Receipts Personal income taxes 1,162.1 43.5 Excise taxes and customs duties 99.9 3.7 Corporate income taxes 380.8 14.3 Taxes from the rest of the world 13.4 0.5 Contributions for social insurance 953.0 35.7 Interest receipts and rents and royalties 25.1 0.9 Current transfer receipts from business and persons 39.4 1.5 Current surplus of government enterprises − 2.3 − 0.0 Total 2,671.4 100.0 Current Expenditures Consumption expenditures 856.0 29.6 Transfer payments to persons 1,270.7 43.9 Transfer payments to the rest of the world 38.6 1.3 Grants-in-aid to state and local governments 377.5 13.1 Interest payments 302.4 10.5 Subsidies 46.7 1.6 2,892.0 Net federal government saving—surplus (+) or deficit (−) (Total current receipts − Total current expenditures) − 220.6 Source: U.S. Department of Commerce, Bureau of Economic Analysis.

The Federal Budget The Budget in 2007
federal surplus (+) or deficit () Federal government receipts minus expenditures.

The Federal Budget Fiscal Policy Since 1993: The Clinton and Bush Administrations  FIGURE 9.4 Federal Personal Income Taxes as a Percentage of Taxable Income, 1993 I–2007 IV

The Federal Budget Fiscal Policy Since 1993: The Clinton and Bush Administrations  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–2007 IV

The Federal Budget Fiscal Policy Since 1993: The Clinton and Bush Administrations  FIGURE 9.6 The Federal Government Surplus (+) or Deficit (–) as a Percentage of GDP, 1993 I–2007 IV

The Federal Budget 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.

The Federal Budget The Federal Government Debt
 FIGURE 9.7 The Federal Government Debt as a Percentage of GDP, 1993 I–2007 IV

The Economy’s Influence on the Government Budget
Tax Revenues Depend on the State of the Economy Tax revenue, on the other hand, depends on taxable income, and income depends on the state of the economy, which the government does not completely control. Some Government Expenditures Depend on the State of the Economy Transfer payments tend to go down automatically during an expansion. Inflation often picks up when the economy is expanding. This can lead the government to spend more than it had planned to spend. Any change in the interest rate changes government interest payments.

Fiscal Policy In 2008 The Economy’s Influence on the Government Budget
Some Government Expenditures Depend on the State of the Economy Congress Approves Economic-Stimulus Bill Wall Street Journal

Automatic Stabilizers 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 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.

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.

DERIVING THE FISCAL POLICY MULTIPLIERS
THE GOVERNMENT SPENDING AND TAX MULTIPLIERS

net initial increase in spending:
DERIVING THE FISCAL POLICY MULTIPLIERS THE BALANCED-BUDGET MULTIPLIER The balanced-budget multiplier is found by combining the effects of government spending and taxes: increase in spending: - decrease in spending: = net increase in spending In a balanced-budget increase, ΔG = ΔT; so we can substitute: net initial increase in spending: ΔG − ΔG (MPC) = ΔG (1 − MPC)

DERIVING THE FISCAL POLICY MULTIPLIERS
THE BALANCED-BUDGET MULTIPLIER Because MPS = (1 − MPC), the net initial increase in spending is: ΔG (MPS) We can now apply the expenditure multiplier to this net initial increase in spending:

THE CASE IN WHICH TAX REVENUES DEPEND ON INCOME
 FIGURE 9B.1 The Tax Function

 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.

THE GOVERNMENT SPENDING AND TAX MULTIPLIERS ALGEBRAICALLY

Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates
PART VII THE WORLD ECONOMY 35 CHAPTER OUTLINE The Balance of Payments The Current Account The Capital Account The United States as a Debtor Nation Equilibrium Output (Income) in an Open Economy The International Sector and Planned Aggregate Expenditure Imports and Exports and the Trade Feedback Effect Import and Export Prices and the Price Feedback Effect The Open Economy with Flexible Exchange Rates The Market for Foreign Exchange Factors That Affect Exchange Rates The Effects of Exchange Rates on the Economy An Interdependent World Economy Appendix: World Monetary Systems Since 1900

Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates
When people in different countries buy from and sell to each other, an exchange of currencies must also take place. exchange rate The price of one country’s currency in terms of another country’s currency; the ratio at which two currencies are traded for each other.

The study of exchange rates is very important because:
a. Exchange rates determine the course of monetary policy. b. Exchange rates strongly influence interest rates. c. Exchange rates are a factor in determining the flow of international trade. d. All of the above.

The Balance of Payments
foreign exchange All currencies other than the domestic currency of a given country. balance of payments The record of a country’s transactions in goods, services, and assets with the rest of the world; also the record of a country’s sources (supply) and uses (demand) of foreign exchange.

Colombian purchases of real estate in Miami:
a. Increase the U.S. supply of foreign exchange. b. Increase the U.S. demand for foreign exchange. c. Decrease the U.S. supply of foreign exchange. d. Decrease the U.S. demand for foreign exchange.

The Current Account balance of trade A country’s exports of goods and services minus its imports of goods and services. trade deficit Occurs when a country’s exports of goods and services are less than its imports of goods and services in a given period. balance on current account Net exports of goods, plus net exports of services, plus net investment income, plus net transfer payments.

 2.2 (11) Net capital account transactions (13) Balance of payments ( ) 83.6 (12) Statistical discrepancy 657.4 (10) Balance on capital account ( ) 412.7 (9) Change in foreign government assets in the United States 23.0 (8) Change in U.S. government assets abroad (increase is –) 1,451.0 (7) Change in foreign private assets in the United States  1,183.3 (6) Change in private U.S. assets abroad (increase is –) Capital Account  738.6 (5) Balance on current account ( )  104.4 (4) Net transfer payments 74.3 (3) Net investment income  707.9 Income payments on investments 782.2 Income received on investments 106.9 (2) Net export of services  372.3 Import of services 479.2 Export of services  815.4 (1) Net export of goods  1,964.6 Goods imports 1,149.2 Goods exports Current Account Billions of dollars TABLE United States Balance of Payments, 2007

When a nation has spent more on foreign goods and services than it has earned through the sales of its goods and services to the rest of the world, its net wealth position vis-à-vis the rest of the world must have: a. Increased. b. Decreased. c. Remained the same. d. Either increased or decreased, depending on changes in the capital account.

The Capital Account balance on capital account In the United States, the sum of the following (measured in a given period): the change in private U.S. assets abroad, the change in foreign private assets in the United States, the change in U.S. government assets abroad, and the change in foreign government assets in the United States.

If the balance on capital account is positive, the net wealth position of a country has:
a. Increased. b. Decreased. c. Remained the same. d. Either increased or decreased, depending on other changes in the balance of payments account.

The United States as a Debtor Nation Prior to the mid-1970s, the United States had generally run current account surpluses. This began to turn around in the mid-1970s, and by the mid-1980s, the United States was running large current account deficits. In other words, the United States changed from a creditor nation to a debtor nation.

Planned aggregate expenditure in an open economy:
Equilibrium Output (Income) in an Open Economy The International Sector and Planned Aggregate Expenditure Planned aggregate expenditure in an open economy: AE  C + I + G + EX  IM net exports of goods and services (EX  IM) The difference between a country’s total exports and total imports. Determining the Level of Imports marginal propensity to import (MPM) The change in imports caused by a $1 change in income.

Equilibrium Output (Income) in an Open Economy
Solving for Equilibrium  FIGURE Determining Equilibrium Output in an Open Economy In a., planned investment spending (I), government spending (G), and total exports (EX) are added to consumption (C) to arrive at planned aggregate expenditure. However, C + I + G + EX includes spending on imports. In b., the amount imported at every level of income is subtracted from planned aggregate expenditure. Equilibrium output occurs at Y* = 200, the point at which planned domestic aggregate expenditure crosses the 45-degree line.

The Open-Economy Multiplier open-economy multiplier The effect of a sustained increase in government spending (or investment) on income—that is, the multiplier—is smaller in an open economy than in a closed economy. The reason: When government spending (or investment) increases and income and consumption rise, some of the extra consumption spending that results is on foreign products and not on domestically produced goods and services.

The open-economy multiplier is:
a. Larger than the closed-economy multiplier. b. Smaller than the closed-economy multiplier. c. The same as the closed-economy multiplier. d. Zero because imports and exports cancel each other out.

Imports and Exports and the Trade Feedback Effect The Determinants of Imports The same factors that affect households’ consumption behavior and firms’ investment behavior are likely to affect the demand for imports. The Determinants of Exports The demand for U.S. exports depends on economic activity in the rest of the world—rest-of-the-world real wages, wealth, nonlabor income, interest rates, and so on—as well as on the prices of U.S. goods relative to the price of rest-of-the-world goods. If foreign output increases,

The Trade Feedback Effect trade feedback effect The tendency for an increase in the economic activity of one country to lead to a worldwide increase in economic activity, which then feeds back to that country. An increase in U.S. imports increases other countries’ exports, which stimulates those countries’ economies and increases their imports, which increases U.S. exports, which stimulates the U.S. economy and increases its imports, and so on. This is the trade feedback effect. In other words, an increase in U.S. economic activity leads to a worldwide increase in economic activity, which then “feeds back” to the United States.

Imports and Exports and the Trade Feedback Effect Export prices of other countries affect U.S. import prices. The general rate of inflation abroad is likely to affect U.S. import prices. If the inflation rate abroad is high, U.S. import prices are likely to rise. The Price Feedback Effect price feedback effect The process by which a domestic price increase in one country can “feed back” on itself through export and import prices. An increase in the price level in one country can drive up prices in other countries. This in turn further increases the price level in the first country.

If the inflation rate in Colombia is high, the prices of Colombian exports will ___________, and U.S import prices are likely to _________. a. increase; rise b. increase; fall c. decrease; rise d. decrease; fall

REVIEW TERMS AND CONCEPTS
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 1. Disposable income Yd ≡ Y − T 2. AE ≡ C + I + G 3. Government budget deficit ≡ G − T 4. Equilibrium in an economy with government: Y = C + I + G 5. Saving/investment approach to equilibrium in an economy with government: S + T = I + G 6. Government spending multiplier ≡ 7. Tax multiplier ≡ 8. Balanced-budget multiplier ≡ 1

REVIEW TERMS AND CONCEPTS
marginal propensity to import (MPM) net exports of goods and services (EX - IM) price feedback effect trade deficit trade feedback effect Planned aggregate expenditure in an open economy: AE  C + I + G + EX - IM Open-economy multiplier:

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