Download Principles of Economics, Case/Fair/Oster, 11e

PRINCIPLES OF
ECONOMICS
E L E V E N T H E D I T I O N
CASE  FAIR  OSTER
PEARSON
Prepared by: Fernando Quijano w/Shelly
1 ofTefft
40
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The Government and
Fiscal Policy
24
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 2012
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
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fiscal policy The government’s spending and taxing policies.
monetary policy The behavior of the Federal Reserve concerning the nation’s
money supply.
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Government in the Economy
discretionary fiscal policy Changes 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
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 FIGURE 24.1 Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow
of Income
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The disposable income (Yd) of households must end up as either consumption
(C) or saving (S). Thus,
Yd  C  S
Because disposable income is aggregate income (Y) minus net taxes (T), we
can write another identity:
Y  T  C S
By adding T to both sides:
Y  C S  T
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).
AE  C  I  G
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budget deficit The difference between what a government spends and what it
collects in taxes in a given period: G − T.
budget deficit ≡ G − T
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.
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Planned Investment
The government can affect investment behavior through its tax treatment of
depreciation and other tax policies.
Planned investment depends on the interest rate, both of which we continue to
assume are fixed for purposes of this chapter.
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The Determination of Equilibrium Output (Income)
Y=C+I+G
TABLE 24.1 Finding Equilibrium for I = 100, G = 100, and T = 100
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
Planned
Planned
Unplanned
Output
Net Disposable Consumption Saving Investment Government Aggregate
Inventory Adjustment
(Income) Taxes
Income
Spending
S
Spending Purchases Expenditure
Change
to DisequiY
T
Yd ≡Y −T C = 100 + .75 Yd Yd – C
I
G
C + I + G Y − (C + I + G)
librium
300
100
200
250
− 50
100
100
450
− 150
Output ↑
500
100
400
400
0
100
100
600
− 100
Output ↑
700
100
600
550
50
100
100
750
− 50
Output ↑
900
100
800
700
100
100
100
900
0
Equilibrium
1,100
100
1,000
850
150
100
100
1,050
+ 50
Output ↓
1,300
100
1,200
1,000
200
100
100
1,200
+ 100
Output ↓
1,500
100
1,400
1,150
250
100
100
1,350
+ 150
Output ↓
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 FIGURE 24.2 Finding
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.
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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
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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
The Government Spending Multiplier
government spending multiplier 
1
1

MPS 1  MPC
government spending multiplier The ratio of the change in the equilibrium
level of output to a change in government spending.
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TABLE 24.2 Finding Equilibrium after a Government Spending Increase of 50 (G Has Increased
from 100 in Table 24.1 to 150 Here)
(1)
(2)
(3)
(4)
Output
Net Disposable Consumption
(Income) Taxes
Income
Spending
Y
T
Yd ≡Y −T C = 100 + .75 Yd
(5)
(6)
(7)
(8)
(9)
(10)
Unplanned
Planned
Planned
Inventory
Saving Investment Government Aggregate
Change
Adjustment
S
Spending Purchases Expenditure Y − (C + I +
to
Yd – C
I
G
C+I+G
G)
Disequilibrium
300
100
200
250
 50
100
150
500
 200
Output ↑
500
100
400
400
0
100
150
650
 150
Output ↑
700
100
600
550
50
100
150
800
 100
Output ↑
900
100
800
700
100
100
150
950
 50
Output ↑
1,100
100
1,000
850
150
100
150
1,100
0
1,300
100
1,200
1,000
200
100
150
1,250
+ 50
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Equilibrium
Output ↓
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 FIGURE 24.3 The 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.
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The Tax Multiplier
tax multiplier The ratio of change in the equilibrium level of output to a
change in taxes.
 1 
 Y  (initial increase in aggregate expenditure)  

 MPS 
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:
1 
MPC 


Y  (  T  MPC )  
  T  

 MPS 
 MPS 
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:
tax multiplier  
 
MPC
MPS
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The Balanced-Budget Multiplier
balanced-budget multiplier The 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.
balanced-budget multiplier  1
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TABLE 24.3 Finding Equilibrium after a Balanced-Budget Increase in G and T of 200 Each
(Both G and T Have Increased from 100 in Table 24.1 to 300 Here)
(1)
Output
(Income)
Y
(2)
(3)
(4)
Net Disposable Consumption
Taxes
Income
Spending
T
Yd ≡Y − T C = 100 + .75 Yd
(5)
(6)
(7)
(8)
(9)
Planned
Planned
Unplanned
Investment Government Aggregate
Inventory
Spending Purchases Expenditure
Change
I
G
C + I + G Y − (C + I + G)
Adjustment
to
Disequilibrium
500
300
200
250
100
300
650
−150
Output ↑
700
300
400
400
100
300
800
−100
Output ↑
900
300
600
550
100
300
950
−50
Output ↑
1,100
300
800
700
100
300
1,100
0
1,300
300
1,000
850
100
300
1,250
+ 50
Output ↓
1,500
300
1,200
1,000
100
300
1,400
+ 100
Output ↓
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Equilibrium
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TABLE 24.4 Summary of Fiscal Policy Multipliers
Policy Stimulus
Multiplier
Government
spending
multiplier
Increase or decrease in the
level of government
purchases: ∆G
1
MPS
Tax multiplier
Increase or decrease in the
level of net taxes: ∆T
 MPC
MPS
Balancedbudget
multiplier
Simultaneous balanced-budget
increase or decrease in the
level of government
purchases and
net taxes: ∆G = ∆T
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1
Final Impact on
Equilibrium Y
G 
T 
1
MPS
 MPC
MPS
G
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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.
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The Federal Budget
Because fiscal policy is the manipulation of items in the federal budget, that
budget is relevant to our study of macroeconomics.
federal budget The budget of the federal government.
An enormously complicated document up to thousands of pages each year, the
federal budget lists in detail all the things the government plans to spend
money on and all the sources of government revenues for the coming year.
It is the product of a complex interplay of social, political, and economic forces.
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The Budget in 2012
TABLE 24.5 Federal Government Receipts and Expenditures, 2012 (Billions of Dollars)
Current receipts
Personal income taxes
Excise taxes and customs duties
Corporate income taxes
Taxes from the rest of the world
Contributions for social insurance
Interest receipts and rents and royalties
Current transfer receipts from business and persons
Current surplus of government enterprises
Total
Current expenditures
Consumption expenditures
Transfer payments to persons
Transfer payments to the rest of the world
Grants-in-aid to state and local governments
Interest payments
Subsidies
Total
Net federal government saving–surplus (+) or deficit (−)
(Total current receipts − Total current expenditures)
Amount
Percentage of Total
1,137.8
116.1
373.7
17.3
934.8
53.4
59.2
− 17.8
2,674.5
42.5
4.3
14.0
0.6
35.0
2.0
2.2
− 0.7
100.0
1,059.6
1,773.2
76.4
468.0
318.5
60.4
3,756.1
28.2
47.2
2.0
12.5
8.5
1.6
100.0
− 1,081.6
federal surplus (+) or deficit (−) Federal government receipts minus
expenditures.
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Fiscal Policy Since 1993: The Clinton, Bush, and Obama Administrations
 FIGURE 24.4 Federal Personal Income Taxes as a Percentage of Taxable Income, 1993 I–2012 IV
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 FIGURE 24.5 Federal Government Consumption Expenditures as a Percentage of GDP and
Federal Transfer Payments and Grants-in-Aid as a Percentage of GDP, 1993 I–2012 IV
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 FIGURE 24.6 The Federal Government Surplus (+) or Deficit (−) as a Percentage of GDP,
1993 I–2012 IV
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EC ON OMIC S IN PRACTICE
The U.S. Congress Fights about the Budget
In January 2013, Congress signed the American Tax Relief Act (ATRA), which
retained many of the earlier Bush tax cuts, while modifying others. But the
specter of automatic spending cuts remained.
In the spring of 2013, arguments about the shape of the 2014 budget were
raging, as members of the House commented on a budget proposal of Paul
Ryan, Republican Congressman from Wisconsin.
Representative Eddie Bernice Johnson of Texas, a Democrat, had this to say
about Congressman Ryan’s bill: “This budget would not only jeopardize
seniors, families and the most vulnerable in our society, it would also destroy
jobs and put our nation’s economic recovery at risk.”
The Congress heard a different view from Andy Barr, a new Republican
Congressman from Kentucky: “Families and small businesses should be able
to keep more of their hard-earned income instead of having it wasted by
Washington bureaucrats.”
THINKING PRACTICALLY
1. How would you describe the views of the two people quoted on the benefits of
government spending?
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The Federal Government Debt
federal debt The total amount owed by the federal government.
privately held federal debt The privately held (non-government-owned) debt
of the U.S. government.
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 FIGURE 24.7 The Federal Government Debt as a Percentage of GDP, 1993 I–2012 IV
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EC ON OMIC S IN PRACTICE
The Debt Clock
Next time you are in New York City, wander by West 44th Street and the Avenue
of the Americas.
Located on an outside wall is a U.S. Debt Clock, mounted by Seymour Durst, a
N.Y. real estate developer.
Rather than showing us the passage of time, as would a conventional clock,
this clock shows us the mounting of the U.S. debt.
Durst was an early worrier about the debt! Needless to say, it sped up during
the Obama administration. See Figure 24.7.
THINKING PRACTICALLY
1. For a few years beginning in 2000, the clock was stopped and covered up.
Can you guess why based on the data you have seen in this chapter?
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The Economy’s Influence on the Government Budget
Automatic Stabilizers and Destabilizers
automatic stabilizers Revenue 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 drag The negative effect on the economy that occurs when average tax
rates increase because taxpayers have moved into higher income brackets
during an expansion.
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Full-Employment Budget
full-employment budget What the federal budget would be if the economy
were producing at the full-employment level of output.
structural deficit The deficit that remains at full employment.
cyclical deficit The deficit that occurs because of a downturn in the
business cycle.
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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.
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REVIEW TERMS AND CONCEPTS
automatic destabilizers
privately held federal debt
automatic stabilizers
structural deficit
balanced-budget multiplier
tax multiplier
budget deficit
Disposable income Yd ≡ Y − T
cyclical deficit
AE ≡ C + I + G
discretionary fiscal policy
Government budget deficit ≡ G − T
disposable, or after-tax, income (Yd)
Equilibrium in an economy with a
government: Y = C + I + G
federal budget
federal debt
federal surplus (+) or deficit (−)
fiscal drag
fiscal policy
full-employment budget
government spending multiplier
monetary policy
net taxes (T)
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Saving/investment approach to
equilibrium in an economy with a
government: S + T = I + G
Government spending multiplier

1
1

MPS 1  MPC
 MPC 

 MPS 
7. Tax multiplier ≡  
8. Balanced-budget multiplier ≡ 1
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CHAPTER 24 APPENDIX A
Deriving the Fiscal Policy Multipliers
The Government Spending and Tax Multipliers
We can derive the multiplier algebraically using our hypothetical consumption
function:
C  a  b(Y  T )
The equilibrium condition is
Y  C I  G
By substituting for C, we get
Y  a  b(Y  T )  I  G
Y  a  bY  bT  I  G
This equation can be rearranged to yield
Y  bY  a  I  G  bT
Y (1  b)  a  I  G  bT
Now solve for Y by dividing through by (1 − b):
1
Y 
(a  I  G  bT )
1  b
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The Balanced-Budget Multiplier
It is easy to show formally that the balanced-budget multiplier = 1.
G
initial increase in spending:
− initial decrease in spending:
C  T ( MPC )
= net initial increase in spending
G  T ( MPC )
In a balanced-budget increase, ∆G = ∆T; so in the above equation for the
net initial increase in spending we can substitute ∆G for ∆T.
∆G − ∆G (MPC) = ∆G (1 − MPC)
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Because MPS = (1 − MPC), the net initial increase in spending is:
∆G (MPS)
 1 
We can now apply the expenditure multiplier 
 to this net initial
 MPS 
increase in spending:
 1 
Y  G ( MPS ) 
  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.
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CHAPTER 24 APPENDIX B
The Case in Which Tax Revenues Depend on Income
 FIGURE 24B.1 The Tax Function
This graph shows net taxes
(taxes minus transfer
payments) as a function of
aggregate income.
Yd  Y  T
Yd  Y  (200  1 / 3Y )
Yd  Y  200  1 / 3Y
C  100  .75Yd
C  100  .75(Y  200  1 / 3Y )
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Y  C  I G
Y  100  .75(Y  200  1/ 3Y )  100  100
I
G
C
Y  100  .75Y  150  25Y  100  100
Y  450  .5Y
.5Y  450
 FIGURE 24B.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.
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The Government Spending and Tax Multipliers Algebraically
C  a  b(Y  T )
C  a  b(Y  T0  tY )
C  a  bY  bT0  btY
We know that Y = C + I + G. Through substitution we get
Y  a  bY  bT  btY  I  G
0
C
Solving for Y:
1
Y
(a  I  G  bT0 )
1  b  bt
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This means that a $1 increase in G or I (holding a and T0 constant) will
increase the equilibrium level of Y by
1
1  b  bt
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
b
1  b  bt
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