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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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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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The Government Spending Multiplier
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 Government Spending Multiplier
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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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The Economys Influenceon the Government Budget
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 Economys Influenceon the Government Budget
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 Economys Influenceon the Government Budget
The cyclical deficitis thedeficit that occurs because of a
downturn in the business cycle.
The structural deficitis thedeficit that remains at full
employment.