chp09 - the government and fiscal policy

8/3/2019 Chp09 - The Government and Fiscal Policy

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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair

The Government

and Fiscal Policy

Prepared by: Fernando Quijanoand Yvonn Quijano

Appendix A: Deriving the Fiscal Policy Multipliers

Appendix B: The Case in Which Tax Revenues

Depend on Income


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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 2 of 35

Government in the Economy

Nothing arouses as much controversy asthe role of government in the economy.

Government can affect the macroeconomyin two ways:

Fiscal policyis the manipulation ofgovernment spending and taxation.

Monetary policyrefers to the behavior of theFederal Reserve regarding the nations moneysupply.


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Government in the Economy

Discretionary fiscal policyrefers todeliberate changes in taxes or spending.

The government can not control certain

aspects of the economy related to fiscalpolicy. For example:

The government can control tax rates but nottax revenue. Tax revenue depends on

household income and the size of corporateprofits.

Government spending depends on governmentdecisions and the state of the economy.


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Net Taxes (T), and Disposable Income (Yd)

Net taxesare taxes paid by firmsand households to the governmentminus transfer payments made tohouseholds by the government.

Disposable, or after-tax, income(Yd)equals total income minus

taxes.

Y Y Td


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The Budget Deficit

A governments budget deficitis thedifference between what it spends (G) andwhat it collects in taxes (T) in a given

period:

Budget def G Ticit

If Gexceeds T, the government must

borrow from the public to finance thedeficit. It does so by selling Treasurybonds and bills. In this case, a part ofhousehold saving (S) goes to the

government.


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Adding Taxes to theConsumption Function

The aggregate consumption function

is now a function of disposable, orafter-tax, income.

C a bY d

Y Y Td

C a b Y T ( )


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Equilibrium Output: Y= C+ I+ G

Finding Equilibrium for I= 100, G= 100, and T= 100(All Figures in Billions of Dollars)

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

OUTPUT(INCOME)

Y

NETTAXES

T

DISPOSABLEINCOME

Yd/YTCONSUMPTION

SPENDING(C= 100 + .75 Yd)

SAVINGS

(YdC)

PLANNEDINVESTMENT

SPENDINGI

GOVERNMENTPURCHASES

G

PLANNEDAGGREGATE

EXPENDITUREC+ I+ G

UNPLANNEDINVENTORY

CHANGEY (C+ I+ G)

ADJUSTMENTTO

DISEQUILIBRIUM

300 100 200 250 50 100 100 450 150 Output8

500 100 400 400 0 100 100 600 100 Output8

700 100 600 550 50 100 100 750

50 Output8

900 100 800 700 100 100 100 900 0 Equilibrium

1,100 100 1,000 850 150 100 100 1,050 + 50 Output9

1,300 100 1,200 1,000 200 100 100 1,200 + 100 Output9

1,500 100 1,400 1,150 250 100 100 1,350 + 150 Output9

C Yd 100 75. C Y T 100 75. ( )


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The Government Spending Multiplier

The government spendingmultiplieris the ratio of the changein the equilibrium level of output to achange in government spending.

Government multiplierMPS

spending 1


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Finding Equilibrium After a $50 Billion Government Spending Increase(All Figures in Billions of Dollars; GHas Increased From 100 in Table 25.1 to 150 Here)

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

OUTPUT

(INCOME)Y

NET

TAXEST

DISPOSABLE

INCOMEYd/YT

CONSUMPTION

SPENDING(C= 100 + .75 Yd)

SAVING

S(YdC)

PLANNEDINVESTMENT

SPENDINGI

GOVERNMENT

PURCHASESG

PLANNEDAGGREGATE

EXPENDITUREC+ I+ G

UNPLANNEDINVENTORY

CHANGEY (C+ I+ G)

ADJUSTMENT

TODISEQUILIBRIUM

300 100 200 250 50 100 150 500 200 Output8

500 100 400 400 0 100 150 650 150 Output8

700 100 600 550 50 100 150 800 100 Output8

900 100 800 700 100 100 150 950

50 Output8

1,100 100 1,000 850 150 100 150 1,100 0 Equilibrium

1,300 100 1,200 1,000 200 100 150 1,250 + 50 Output9


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The Tax Multiplier

A tax cut increases disposableincome, and leads to addedconsumption spending. Income will

increase by a multiple of thedecrease in taxes.

A tax cut has no direct impact on

spending. The multiplier for achange in taxes is smaller than themultiplier for a change in governmentspending.


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The Tax Multiplier

YMPS

(initial increase in aggregate expenditure)

1

Y T MPC MPS

T MPCMPS

( ) 1

Tax multipMPC

MPS

lier


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The Balanced-Budget Multiplier

The balanced-budget multiplieristhe ratio of change in the equilibriumlevel of output to a change ingovernment spending where thechange in government spending isbalanced by a change in taxes so as

not to create any deficit.


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The Balanced-Budget Multiplier

Finding Equilibrium After a $200 Billion Balanced Budget Increase in Gand T(All Figures in Billions of Dollars; Gand THave Increased From 100 in Table 25.1 to 300 Here)

(1) (2) (3) (4) (5) (6) (7) (8) (9)

OUTPUT(INCOME)

Y

NETTAXES

T

DISPOSABLEINCOME

Yd/ YTCONSUMPTION

SPENDING

(C= 100 + .75 Yd)

PLANNEDINVESTMENT

SPENDING

I

GOVERNMENTPURCHASES

G

PLANNEDAGGREGATE

EXPENDITURE

C+ I+ G

UNPLANNEDINVENTORY

CHANGE

Y (C+ I+ G)ADJUSTMENT

TO

DISEQUILIBRIUM

500 300 200 250 100 300 650 150 Output8

700 300 400 400 100 300 800 100 Output8

900 300 600 550 100 300 950 50 Output8

1,100 300 800 700 100 300 1,100 0 Equilibrium

1,300 300 1,000 850 100 300 1,250 + 50 Output9

1,500 300 1,200 1,000 100 300 1,400 + 100 Output9


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Fiscal Policy Multipliers

Summary of Fiscal Policy Multipliers

POLICY STIMULUS MULTIPLIERFINAL IMPACT ON

EQUILIBRIUM Y

Government-

spendingmultiplier

Increase or decrease in the

level of governmentpurchases:

Tax multiplier Increase or decrease in thelevel of net taxes:

Balanced-budgetmultiplier

Simultaneous balanced-budgetincrease or decrease in thelevel of government purchasesand net taxes:

1

1MPS

MPC

MPS

G MPS1

TMPC

MPS

G


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The Federal Budget

The federal budgetis the budget ofthe federal government.

The difference between the federalgovernments receipts and its

expenditures is the federal surplus(+) or deficit (-).


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The Federal Budget

Federal Government Receipts and Expenditures, 2000 (Billions of Dollars)

AMOUNTPERCENTAGE

OF TOTAL

Receipts

Personal taxes 1,010.1 49.6Corporate taxes 193.2 9.5Indirect business taxes 111.0 5.5Contributions for social insurance 720.6 35.4

Total 2,034.9 100.0

Current ExpendituresConsumption 514.1 26.9Transfer payments 831.9 43.6Grants-in-aid to state and local governments 274.2 14.4Net interest payments 236.9 12.4Net subsidies of government enterprises 52.5 2.7

Total 1,909.6 100.0

Current Surplus (+) or deficit () (Receipts Current Expenditures) + 125.3

Source: U.S. Department of Commerce, Bureau of Economic Analysis.


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The Federal Government Surplus (+) orDeficit (-) as a Percentage of GDP, 1970 I2003 II


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The Debt

The federal debtis the total amountowed by the federal government. Thedebt is the sum of all accumulated

deficits minus surpluses over time.

Some of the federal debt is held bythe U.S. government itself and some

by private individuals. The privatelyheld federal debtis the private (non-government-owned) portion of thefederal debt.


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The Federal Government Debt as aPercentage of GDP, 1970 I2003 II

The percentage began to fall in the mid 1990s.


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The Economys Influenceon the Government Budget

Automatic stabilizersarerevenue and expenditure items

in the federal budget thatautomatically change with thestate of the economy in such away as to stabilize GDP.


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Fiscal dragis the negativeeffect on the economy that

occurs when average tax ratesincrease because taxpayershave moved into higher incomebrackets during an expansion.


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The full-employment budgetis what the federal budget

would be if the economy wereproducing at a full-employmentlevel of output.


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The cyclical deficitis thedeficit that occurs because of a

downturn in the business cycle.

The structural deficitis thedeficit that remains at full

employment.

chp09 - the government and fiscal policy

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