Prepared by: Fernando Quijano & Shelly Tefft

1. P R I N C I P L E S O F MACROECONOMICS T E N T H E D I T I O N CASE FAIR OSTER Prepared by: Fernando Quijano & Shelly Tefft

3. 9 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 2009 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

4. fiscal policyThe government’s spending and taxing policies. monetary policyThe behavior of the Federal Reserve concerning the nation’s money supply.

5. The behavior of the Federal Reserve concerning the nation’s money supply is called: a. Discretionary fiscal policy. b. Automatic fiscal policy. c. Budgetary policy. d. Monetary policy.

6. The behavior of the Federal Reserve concerning the nation’s money supply is called: a. Discretionary fiscal policy. b. Automatic fiscal policy. c. Budgetary policy. d. Monetary policy.

7. Government in the Economy discretionary fiscal policyChanges 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

8. Over which of the following categories does the government have more control? a. Tax revenue. b. Government expenditures. c. Tax rates. d. The size of corporate profits.

9. Over which of the following categories does the government have more control? a. Tax revenue. b. Government expenditures. c. Tax rates. d. The size of corporate profits.

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

11. Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Yd) The disposable income (Yd) of households must end up as either consumption (C) or saving (S). Thus, Because disposable income is aggregate income (Y) minus net taxes (T), we can write another identity: By adding T to both sides: 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).

12. Select the best answer. Households use their disposable income (Yd) to do the following: a. Consume. b. Consume and save. c. Consume, save, and pay taxes. d. Consume, save, pay taxes, and buy imports.

13. Select the best answer. Households use their disposable income (Yd) to do the following: a. Consume. b. Consume and save. c. Consume, save, and pay taxes. d. Consume, save, pay taxes, and buy imports.

14. Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Yd) budget deficitThe difference between what a government spends and what it collects in taxes in a given period: G−T. budget deficit ≡G − T

15. Government in the Economy 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.

16. When government enters the circular flow of income, which of the following is an expression for planned aggregate expenditure? a. Y − T b. C + S + T c. C + I + G d. G – T

17. When government enters the circular flow of income, which of the following is an expression for planned aggregate expenditure? a. Y − T b. C + S + T c. C + I + G d. G – T

18. Government in the Economy 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.

19. Government in the Economy The Determination of Equilibrium Output (Income) Y = C + I + G

20. Government in the Economy The Determination of Equilibrium Output (Income)  FIGURE 9.2Finding 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.

21. 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

22. In the circular flow that includes households, firms, and government, which of the following expressions is the leakages/injections approach to equilibrium? a. Y = C + I + G. b. C + S = I + G. c. Y = a + bT + I + G. d. S + T = I + G.

23. In the circular flow that includes households, firms, and government, which of the following expressions is the leakages/injections approach to equilibrium? a. Y = C + I + G. b. C + S = I + G. c. Y = a + bT + I + G. d. S + T = I + G.

24. 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

25. Fiscal Policy at Work: Multiplier Effects The Government Spending Multiplier government spending multiplierThe ratio of the change in the equilibrium level of output to a change in government spending.

26. Fiscal Policy at Work: Multiplier Effects The Government Spending Multiplier

27. How much of an increase in government spending would be required to generate a $200 billion increase in the equilibrium level of output? a. An amount less than $200 billion in government spending. b. An amount greater than $200 billion in government spending. c. Exactly $200 billion in government spending. d. None of the above. Equilibrium output does not change with changes in government spending.

28. How much of an increase in government spending would be required to generate a $200 billion increase in the equilibrium level of output? a.An amount less than $200 billion in government spending. b. An amount greater than $200 billion in government spending. c. Exactly $200 billion in government spending. d. None of the above. Equilibrium output does not change with changes in government spending.

29. Fiscal Policy at Work: Multiplier Effects The Government Spending Multiplier  FIGURE 9.3The 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.

30. Fiscal Policy at Work: Multiplier Effects The Tax Multiplier tax multiplierThe ratio of change in the equilibrium level of output to a change in taxes. 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: 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:

31. Which of the following formulas shows the impact of a change in taxes on equilibrium income? a. Y = a + b(Y – T) + I + G b. Y = 1/(1 – b) * (a – bT + I + G) c. S + T = I + G d. – ∆T *(b/1 – b) e. C + S = I + G

32. Which of the following formulas shows the impact of a change in taxes on equilibrium income? a. Y = a + b(Y – T) + I + G b. Y = 1/(1 – b) * (a – bT + I + G) c. S + T = I + G d. – ∆T *(b/1 – b) e. C + S = I + G

33. Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier balanced-budget multiplierThe 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.

34. Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier

35. What happens when there is a simultaneous increase in government spending of $100 and a lump-sum tax of $100? • a. Equilibrium income would increase by $100, or the amount of increase in G. • b. Equilibrium income would decrease by $100, or the amount of increase in T. • Equilibrium income would decrease by $200, or double the amount of the increase in T. • Nothing happens. Equilibrium income remains the same because the amount of government spending (G) is compensated by the amount of taxation (T).

36. What happens when there is a simultaneous increase in government spending of $100 and a lump-sum tax of $100? • a. Equilibrium income would increase by $100, or the amount of increase in G. • b. Equilibrium income would decrease by $100, or the amount of increase in T. • Equilibrium income would decrease by $200, or double the amount of the increase in T. • Nothing happens. Equilibrium income remains the same because the amount of government spending (G) is compensated by the amount of taxation (T).

37. Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier

38. Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier 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.

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

40. The federal budget can be conceived as: a. A political document that dispenses favors to some groups and places burdens on others. b. A reflection of goals the government wants to achieve. c. An embodiment of some beliefs about how (if at all) the government should manage the macroeconomy. d. All of the above.

41. The federal budget can be conceived as: a. A political document that dispenses favors to some groups and places burdens on others. b. A reflection of goals the government wants to achieve. c. An embodiment of some beliefs about how (if at all) the government should manage the macroeconomy. d. All of the above.

42. The Federal Budget The Budget in 2009

43. The Federal Budget The Budget in 2009 federal surplus (+) or deficit (−) Federal government receipts minus expenditures.

44. The Federal Budget Fiscal Policy Since 1993: The Clinton, Bush, and Obama Administrations  FIGURE 9.4Federal Personal Income Taxes as a Percentage of Taxable Income, 1993 I–2010 I

45. The Federal Budget Fiscal Policy Since 1993: The Clinton, Bush, and Obama Administrations  FIGURE 9.5Federal Government Consumption Expenditures as a Percentage of GDP and Federal Transfer Payments and Grants-in-Aid as a Percentage of GDP, 1993 I–2010 I

46. The Federal Budget Fiscal Policy Since 1993: The Clinton, Bush, and Obama Administrations  FIGURE 9.6The Federal Government Surplus (+) or Deficit (–) as a Percentage of GDP, 1993 I–2010 I

47. After a large deficit buildup in the 1980s, the federal government deficit: a. Continued to worsen steadily throughout the 1990s and into the 2000s. b. Turned into a surplus during the two Clinton administrations. c. Was vastly diminished during the G.W. Bush administrations. d. Was virtually eliminated by the Obama administration.

48. After a large deficit buildup in the 1980s, the federal government deficit: a. Continued to worsen steadily throughout the 1990s and into the 2000s. b. Turned into a surplus during the two Clinton administrations. c. Was vastly diminished during the G.W. Bush administrations. d. Was virtually eliminated by the Obama administration.

49. The Federal Budget The Federal Government Debt federal debtThe total amount owed by the federal government. privately held federal debtThe privately held (non-government-owned) debt of the U.S. government.

50. The Federal Budget The Federal Government Debt  FIGURE 9.7The Federal Government Debt as a Percentage of GDP, 1993 I–2010 1