chapter twenty five the government and fiscal policy

Chapter Twenty FiveChapter Twenty Five

The Government and The Government and Fiscal PolicyFiscal Policy

Government in the EconomyGovernment in the Economy

Fiscal Authority: Congress and the President and state and local officialsResponsibilities:

–Set purchasing levels (G)

–Set taxes (T)We’ll assume that G and T are set at constant levels.

Disposable IncomeDisposable Income

Net Taxes: taxes minus transfersDisposable income: income minus taxes

Yd = Y - T

Aggregate ExpendituresAggregate Expenditures- with Government -- with Government -

AE = C + I + GAE = C + I + G

Yd = Y - T

Yd = C + S

Y - T = C + S

Y = C + S + T

The Model EconomyThe Model Economy

C = 500 + 0.75*(Income - Taxes)

= 500 + 0.75*Yd

I = 50 G = 100 and T = 60.

EquilibriumEquilibriumC + I + G = AE

– 500 + 0.75*Incomed + 50 + 100 = AE

– 650 + 0.75*Incomed = AE

AE = Income

–650 + 0.75*Incomed = Income

–650 + 0.75*(Income - 60) = Income–605= (1 - 0.75)*Income–2420 = Income2420 = Income

EquilibriumEquilibrium

Income = 2420– C = 500 + 0.75*(2420 - 60) = 2270– S = 2420 - Taxes - C = 90

C + I + G = 2270 + 50 + 150 = 2420 = Y S + Taxes = 150 = 100 + 50 = G + I

EquilibriumEquilibrium

Income = 2420– C = 500 + 0.75*(2420 - 60) = 2270– S = 2420 - Taxes - C = 90

C + I + G = 2270 + 50 + 150 = 2420 = Y S + Taxes = 150 = 100 + 50 = G + I

Note that S + T = G + I

Consumption=500+.75Yd

Aggregate PlannedExpenditures

Income

Savings + Taxes

500

550

Investment=$50

C

C+I

C+I+G

Government=100

650

45o

Income

500

C

C+I+G = AE

650

Y=2240

GDP

Aggregate PlannedExpenditures

45o

Income

500

550

C

C+I

C+I+G

650Consumption

Savings + Taxes

2240

Aggregate PlannedExpenditures

45o

Income

500

550

C

C+I

C+I+G

650Consumption

G + I

2240

Aggregate PlannedExpenditures

45o

AE = C + I + G

Income (Y)2950

2950

C = 500 + 0.8*YG=50, T=0

I=40

Expenditures

45o

C + I + G1

Income (Y)2950

2950

C = 500 + 0.8*YG=60, T=0

I=40

Expenditures

Suppose G increases by 10, taxes increase by 0.

3000

3000

C + I + G2

Y increases by 50

45o

The Government Spending The Government Spending MultiplierMultiplier

G = 10 and Y = 50Multiplier = 50/10 = 5Multiplier = 1/(1-MPC) = 5

AE2 = C + I + G

Income (Y)2950

2950 C = 500 + 0.8*YG=50, T=10

I=40

Expenditures

Suppose T increases by 10

2910

2910

AE1 = C + I + G

Y decreases by 40

The Tax MultiplierThe Tax Multiplier

T = 10 and Y = -40Multiplier = -40/10 = -4Multiplier = MPC/(1-MPC) = -4

AE2 = C + I + G

Income (Y)2950

2950

C = 500 + 0.8*YG=60, T=10

I=40

Expenditures

Suppose G increases by 10, T increases by 10

2960

2960

AE1 = C + I + G

Y increasesincreases by 1045o

Balanced Budget MultiplierBalanced Budget Multiplier

G = 10 and Y = 10Multiplier = 10/10 = 1 1

MultipliersMultipliers

= = 1

1-MPC

1

1-MPC

1

1-MPC

Governmentspendingmultiplier

Governmentspendingmultiplier

Investmentspendingmultiplier

Investmentspendingmultiplier

Consumptionspendingmultiplier

Consumptionspendingmultiplier

= =

MultipliersMultipliers

1>MPC

1-MPC> 1

1-MPC

Governmentspendingmultiplier

Governmentspendingmultiplier

Taxdecrease

multiplier

Taxdecrease

multiplier

Balancedbudget

multiplier

Balancedbudget

multiplier>>

The Federal Budget, Deficit, The Federal Budget, Deficit, and Debtand Debt

DeficitDeficit = G - Taxes

–cyclical deficitcyclical deficit: part of deficit which is due to the business cycle

–structural deficitstructural deficit: part of deficit which exists even at full employment

Receipts and OutlaysReceipts and Outlays

Federal Receipts and Outlays, 1939-1994 (Billions of Current Dollars)

0200400600800

1000120014001600

1939 1947 1955 1963 1971 1979 1987 1994

Years

Bil

lion

s of

Dol

lars

Source: "Economic Report of the President, 1995", Table B-74, p. 435.

Receipts

Outlays

Federal DeficitFederal Deficit

Federal Surplus or Deficit, 1939-1994 (Billions of Current Dollars)

-300

-250

-200

-150

-100

-50

0

50

1939 1943 1947 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991

Years

Bil

lion

s of

Dol

lars

Source: "Economic Report of the President, 1995", Table B-74, p. 435.

1994

Measuring the DeficitMeasuring the Deficit

Deficit = Expenditures - TaxesAs a percentage of GDP

Deficit as a Percentage of GDPDeficit as a Percentage of GDP

-35

-30

-25

-20

-15

-10

-5

0

5

1934

1938

1942

1946

1950

1954

1958

1962

1966

1970

1974

1978

1982

1986

1990

1994

1998

National DebtNational Debt

The national debtnational debt refers to the total accumulation of past deficits.

The Economy’s Influence on The Economy’s Influence on the Deficitthe Deficit

Fiscal dragTax revenues that depend on the economyExpenditures that depend on the economyAutomatic stabilizers

Government Deficits and Debt as a Government Deficits and Debt as a Percentage of nominal GDP, 1997, for Percentage of nominal GDP, 1997, for

selected countriesselected countries

Deficit Debt

Canada 0.2 66.5

France 3.2 48.6

Germany 3.1 53.4

Italy 3.2 116.3

Japan 2.7 18.2

United Kingdom 2.0 47.9

United States 0.3 51.7

Review Terms & ConceptsReview Terms & Concepts

Automatic stabilizers Balanced budget

multiplier Budget deficit Cyclical deficit Discretionary fiscal

policy Disposable (after-tax)

income

Federal budget Federal debt Federal deficit Fiscal drag Fiscal policy Full-employment

budget Government spending

multiplier

Review Terms & Concepts Review Terms & Concepts (cont.)(cont.)

Monetary policy Net exports Net taxes Privately held federal

debt Structural deficit Tax multiplier