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. 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

6. 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

7. 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).

8. 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

9. 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.

10. 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.

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

12. 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.

13. 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

14. 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

15. 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.

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

17. 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.

18. 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:

19. 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.

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

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

22. 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.

23. 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.

24. The Federal Budget The Budget in 2009

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

26. 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

27. 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

28. 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

29. 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.

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

31. The Economy’s Influence on the Government Budget Automatic Stabilizers and Destabilizers automatic stabilizersRevenue 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 dragThe negative effect on the economy that occurs when average tax rates increase because taxpayers have moved into higher income brackets during an expansion.

32. E C O N O M I C S I N P R A C T I C E Governments Disagree on How Much More Spending Is Needed The U.S. economy is intertwined with the rest of the world. For that reason, U.S. government leaders are concerned not only with their own fiscal policies but also with those of other governments (and vice versa). President Obama was among the strongest advocates of additional stimulus by governments in a June 2010 summit of the G-20. Spending Fight at G-20 The Wall Street Journal

33. The Economy’s Influence on the Government Budget Full-Employment Budget full-employment budgetWhat the federal budget would be if the economy were producing at the full-employment level of output. structural deficitThe deficit that remains at full employment. cyclical deficitThe deficit that occurs because of a downturn in the business cycle.

34. 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.

35. 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 a government: Y = C + I + G 5. Saving/investment approach to equilibrium in an economy with a government: S + T = I + G 6. Government spending multiplier ≡ 7. Tax multiplier ≡ 8. Balanced-budget multiplier ≡ 1 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)

36. CHAPTER9APPENDIXA Deriving the Fiscal Policy Multipliers The Government Spending and Tax Multipliers We can derive the multiplier algebraically using our hypothetical consumption function: The equilibrium condition is By substituting for C, we get This equation can be rearranged to yield Now solve for Y by dividing through by (1 −b):

37. It is easy to show formally that the balanced-budget multiplier = 1. increase in spending: − decrease in spending: = net increase in spending CHAPTER9APPENDIXA Deriving the Fiscal Policy Multipliers The Balanced-Budget Multiplier In a balanced-budget increase, G = T; so we can substitute: net initial increase in spending: G − G (MPC) = G (1 − MPC)

38. We can now apply the expenditure multiplier to this net initial increase in spending: CHAPTER9APPENDIXA Deriving the Fiscal Policy Multipliers The Balanced-Budget Multiplier Because MPS = (1 − MPC), the net initial increase in spending is: 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.

39. CHAPTER9APPENDIXB 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.

40. CHAPTER9APPENDIXB The Case in Which Tax Revenues Depend on Income  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.

41. CHAPTER9APPENDIXB The Case in Which Tax Revenues Depend on Incomes The Government Spending and Tax Multipliers Algebraically Through substitution we get Solving for Y:

42. CHAPTER9APPENDIXB The Case in Which Tax Revenues Depend on Incomes The Government Spending and Tax Multipliers Algebraically This means that a $1 increase in G or I (holding a and T0 constant) will increase the equilibrium level of Y by 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