5. Federal government expenditures: Purchases. Interest on the national debt. Grants to state and local governments. Transfer payments. An Overview of Government Spending and Taxes

6. The Federal Government’s Share of Total Government Expenditures, 1929–2010

7. Federal Purchases and Federal Expenditures as a Percentage of GDP, 1950–2010

8. Federal Government Expenditures, 2010

9. Federal Government Revenue, 2010

11. AD 1 Equilibrium below full employment. Two options Price Level LRAS Y F Y1Y1 P2P2 AD 2 Goods & Services (real GDP) directs the Economy to full-employment SRAS 1 P1P1 1. Wait for SRAS 1 to shift out to SRAS 2 SRAS 2 P3P3 market self- adjustment may be a lengthy process. e1e1 E2E2 2. Shift AD 1 out to AD 2 E3E3

12. AD 1 Equilibrium above full employment at Y 1. Price Level LRAS Y F Y1Y1 P3P3 AD 2 Goods & Services (real GDP) restrains demand and helps control inflation. SRAS 2 P1P1 1. Will lead to the long-run equilibrium E 3 at a higher price level as SRAS shifts to SRAS 2. or SRAS 1 P2P2 E3E3 2. Reduce demand to AD 2 and lead to equilibrium E 2. e1e1 E2E2

13. 12 of 75 © 2013 Pearson Education, Inc. Publishing as Prentice Hall A Summary of How Fiscal Policy Affects Aggregate Demand Countercyclical Fiscal Policy ProblemType of Policy Actions by Congress and the PresidentResult RecessionExpansionaryIncrease government spending or cut taxes Real GDP and the price level rise. Rising inflation ContractionaryDecrease government spending or raise taxes Real GDP and the price level fall.

14. The initial increase in government purchases is autonomous it is a result of a decision by the government and is not directly caused by changes in the level of real GDP. The increases in consumption spending that result from the initial autonomous increase in government purchases are induced because they are caused by the initial increase in autonomous spending.

15. The Multiplier Effect and Aggregate Demand Multiplier effect The series of induced increases in consumption spending that results from an initial increase in autonomous expenditures.

16. The Multiplier Effect of an Increase in Government Purchases The new spending and increased real GDP in each period is shown in green, and the level of spending from the previous period is shown in orange. The sum of the orange and green areas represents the cumulative increase in spending and real GDP. In total, equilibrium real GDP will increase by $200 billion as a result of an initial increase of $100 billion in government purchases.

17. 16 of 75 © 2013 Pearson Education, Inc. Publishing as Prentice Hall The ratio of the change in equilibrium real GDP to the initial change in government purchases:

18. 17 of 75 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Tax cuts also have a multiplier effect. The tax multiplier is negative because changes in taxes and changes in real GDP move in opposite directions: An increase in taxes reduces disposable income, consumption, and real GDP, and a decrease in taxes raises these. We would expect the tax multiplier to be smaller in absolute value than the government purchases multiplier.

19. 18 of 75 © 2013 Pearson Education, Inc. Publishing as Prentice Hall The Multiplier Effect and Aggregate Supply The economy is initially at point A. An increase in government purchases causes the aggregate demand curve to shift to the right, from AD 1 to the dashed AD curve. The multiplier effect results in the aggregate demand curve shifting further to the right, to AD 2 (point B). Because of the upward- sloping supply curve, the shift in aggregate demand results in a higher price level. In the new equilibrium at point C, both real GDP and the price level have increased. The increase in real GDP is less than indicated by the multiplier effect with a constant price level.

20. 19 of 75 © 2013 Pearson Education, Inc. Publishing as Prentice Hall The Effect of Changes in Tax Rates A change in tax rates has a more complicated effect on equilibrium real GDP than does a tax cut of a fixed amount. The higher the tax rate, the smaller the multiplier effect. A cut in tax rates affects equilibrium real GDP through two channels: 1.A cut in tax rates increases the disposable income of households, which leads them to increase their consumption spending (and saving). 2.A cut in tax rates increases the size of the multiplier effect.

21. 20 of 75 © 2013 Pearson Education, Inc. Publishing as Prentice Hall The Multipliers Work in Both Directions Increases in government purchases and cuts in taxes have a positive multiplier effect on equilibrium real GDP. Decreases in government purchases and increases in taxes also have a multiplier effect on equilibrium real GDP, but in this case, the effect is negative.

23. AD 0 1. Equilibrium at E 0 Price Level LRAS Y0Y0 Y1Y1 AD 1 Goods & Services (real GDP) P0P0 SRAS 1 P1P1 E0E0 e1e1 2. AD decreases to AD 1 and output falls to Y 1

24. AD 0 3. While policy is being enacted, private investment has begun to recover. Price Level LRAS Y0Y0 Y1Y1 Goods & Services (real GDP) P0P0 SRAS 1 P1P1 AD 2 E0E0 e1e1 4. AD has begun shifting back to AD 0 on its own, the effects of fiscal policy over-shift AD to AD 2. AD 1

25. AD 0 The price level in the economy rises (from P 1 to P 2 ) as the economy is now overheating. Price Level LRAS Y 0 Y1Y1 P2P2 Goods & Services (real GDP) P0P0 SRAS 1 P1P1 AD 2 E0E0 e1e1 e2e2 Y2Y2 Unless the expansionary fiscal policy is reversed, wages and other resource prices will eventually increase, shifting SRAS back to SRAS 2 (driving the price level up to P 3 ). P3P3 SRAS 2 E3E3

26. AD 0 1. Demand shifts AD out to AD 2, and prices upward to P 2. Price Level LRAS Y0Y0 P2P2 Goods & Services (real GDP) P0P0 SRAS 1 E0E0 Y2Y2 2. Restrictive Fiscal Policy is considered AD 2 e2e2

27. AD 1 AD 0 2. The price level falls (from P 2 to P 1 ) as the economy is thrown into a recession. Price Level LRAS Y0Y0 Y1Y1 P2P2 Goods & Services (real GDP) P0P0 SRAS 1 P1P1 AD 2 E0E0 e1e1 e2e2 Y2Y2 3. With the timing lag, fiscal policy does not work instantaneously.

28. 4. Investment returns to its normal rate (shifting AD 2 back to AD 0 ). Price Level LRAS Y0Y0 Goods & Services (real GDP) P0P0 SRAS 1 AD 2 5. The effects of fiscal policy over-shift AD to AD 1. P2P2 e2e2 Y2Y2 AD 1 Suppose that shifts in AD are difficult to forecast. E0E0 AD 0

30. Increase in budget deficit Higher real interest rates Inflow of financial capital from abroad Decline in private investment Appreciation of the dollar Decline in net exports

31. Did the Stimulus Package of 2009 Work? 1. Congress enacted a tax cut totaling $95 billion that took the form of rebates of taxes already paid that were sent to taxpayers between April and July 2008. 2. One-time tax rebates increase consumers’ current income but not their permanent income, which reflects their expected future income. 3. A tax rebate is likely to increase consumption spending less than would a permanent tax cut.

32. Panel (a) shows how the increases in spending were distributed, and panel (b) shows how the tax cuts were distributed. American Recovery and Reinvestment Act of 2009

33. Year Change in Real GDP Change in the Unemployment Rate Change in Employment (millions of people) 2009 0.9% to 1.9% − 0.3% to − 0.5% 0.5 to 0.9 2010 1.5% to 4.2% − 0.7% to −1.8% 1.3 to 3.3 2011 0.8% to 2.3% − 0.5% to −1.4% 0.9 to 2.7 2012 0.3% to 0.8% − 0.2% to −0.6% 0.4 to 1.1 CBO Estimates of the Effects of the Stimulus Package

34. Why Was the Recession of 2007–2009 So Severe? The recession of 2007-2009 was accompanied by a significant financial crisis, which the U.S. economy had not experienced since the Great Depression of the 1930s.

35. Why Was the Recession of 2007–2009 So Severe? Economic VariableAverage Change Average Duration of Change Number of Countries Unemployment rate +7 %4.8 years14 Real GDP per capita − 9.3% 1.9 years14 Real stock prices − 55.9% 3.4 years22 Real house prices − 35.5% 6 years21 Real government debt + 86% 3 years13 The table shows the average change in key economic variables during the period following a financial crisis for a number of countries, including the United States during the Great Depression and European and Asian countries in the post–World War II era.

36. Duration Decline in Real GDP Peak Unemployment Rate Average for postwar recessions 10.4 months − 1.7% 7.6% Recession of 2007–200918 months − 4.1% 10.1% The recession lasted nearly twice as long as the average of earlier postwar recessions, GDP declined by more than twice the average, and the peak unemployment rate was about one-third higher than the average. Because most people did not see the financial crisis coming, they also failed to anticipate the severity of the 2007–2009 recession. Why Was the Recession of 2007–2009 So Severe?

37. Expenditures < Revenues Expenditures > Revenue Discretionary changes in taxes and/or spending affect the Budget

39. Most of the increase in the federal budget deficit during a typical recession takes place without Congress and the president taking any action, but is instead due to the effects of the automatic stabilizers. Deficits occur automatically during recessions for two reasons: 1.During a recession, wages and profits fall, causing government tax revenues to fall. 2.The government automatically increases its spending on transfer payments when the economy moves into recession.

40. Many economists believe that it is a good idea for the federal government to have a balanced budget when the economy is at potential GDP. Attempting to balance it every year might mean taking actions that would destabilize the economy. Some even argue that the federal government should normally run a deficit, even at potential GDP.

41. The large deficits incurred during World Wars I and II, the Great Depression, and the 1980s and early 1990s increased the ratio of debt to GDP. The large deficits of 2009 to 2011 caused the ratio to spike up to its highest level since 1947.

42. The federal government can raise the funds it needs through taxes or spending cuts. If crowding out occurs, there will be a lower capital stock in the long run and a reduced productive capacity. Some of the debt was incurred to finance improvements in infrastructure, or to finance research and development.

43. “Because fiscal policy actions primarily affect aggregate supply rather than aggregate demand, they are sometimes referred to as supply-side economics.”

44. Tax wedge The difference between the pretax and posttax return to an economic activity. When workers, savers, investors, or entrepreneurs change their behavior as a result of a tax change, economists say that there has been a behavioral response to the tax change. We next look briefly at the effects on aggregate supply of cutting some common taxes. The Long-Run Effects of Tax Policy

45. 1. Individual income tax. Sole proprietorships’ profits and households’ returns from saving are taxed at the individual income tax rates. So, cutting these rates not only reduces the tax wedge faced by workers, thereby increasing the quantity of labor supplied, but also raises the return to entrepreneurship, encouraging the opening of new businesses, and increases the return to saving. People are not working because taxes are too high.

46. Corporate income tax. The federal government taxes the profits earned by corporations under the corporate income tax. Cutting the marginal corporate income tax rate would encourage investment spending by increasing the return corporations receive from new investment goods, potentially increasing the pace of technological change if innovations are embodied in these goods. or… Increase profits of business owners

47. Taxes on dividends and capital gains. Corporations distribute some of their profits in the form of payments known as dividends to shareholders, who may benefit from higher corporate profits by receiving capital gains, which are increases in the prices of assets. Lowering the tax rates on dividends and capital gains increases the supply of loanable funds from households to firms, increasing saving and investment and lowering the equilibrium real interest rate.

48. If the tax code were greatly simplified, the economic resources currently used by the tax preparation industry would be available to produce other goods and services. Put HB Block out of business In addition to wasting resources, the complexity of the tax code may also distort the decisions made by households and firms. A simplified tax code would increase economic efficiency by reducing the number of decisions households and firms make solely to reduce their tax payments. Tax Simplification

49. Figure 16.16 The Supply-Side Effects of a Tax Change The economy’s initial equilibrium is at point A. With no tax change, the long-run aggregate supply curve shifts to the right, from LRAS 1 to LRAS 2. Equilibrium moves to point B, with the price level falling from P 1 to P 2 and real GDP increasing from Y 1 to Y 2. With tax reductions and simplifications, the long-run aggregate supply curve shifts further to the right, to LRAS 3, and equilibrium moves to point C, with the price level falling to P 3 and real GDP increasing to Y 3.

50. Most (?) economists would agree that there are supply-side effects to reducing taxes: Decreasing marginal income tax rates will increase the quantity of labor supplied, cutting the corporate income tax will increase investment spending, and so on. The magnitude of the effects is the subject of considerable debate, however. Economists who are skeptical of their magnitude believe that tax cuts have their greatest effect on aggregate demand rather than on aggregate supply. How Large Are Supply-Side Effects?

51. AD 1 Price Level LRAS 1 Y F2 Y F1 AD 2 Goods & Services (real GDP) With time, lower tax rates promote more rapid growth (shifting LRAS and SRAS out to LRAS 2 and SRAS 2 ). SRAS 1 P 0 SRAS 2 E1E1 LRAS 2 E2E2 1. Lower marginal tax rates shifts AD 1 out to AD 2, and SRAS & LRAS shift to the right. 2. If the tax cuts are financed by budget deficits, AD may expand by more than supply, bringing an increase in the price level.

52. Their share of taxes paid has increased as the top tax rates have declined. This indicates that the supply side effects are strong for these taxpayers. Share of personal income taxes paid by top ½ % of earners 1964-65 Top rate cut from 91% to 70% 1981 Top rate cut from 70% to 50% 1986 Top rate cut from 50% to 30% 1990-93 Top rate raised from 30% to 39.6% 30 % 28 % 26 % 24 % 22 % 20 % 18 % 1960 16 % 14 % 1995199019801975197019651985 2000 1997 Capital gains tax rate cut 2001-2004 Top rate cut from 39.6% to 35% 2005