Macroeconomics: Case Fair Oster

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2012 Pearson Education, Inc. Publishing as Prentice Hall Prepared by: Fernando Quijano & Shelly Tefft
CASE FAIR OSTER
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
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2012 Pearson Education, Inc. Publishing as Prentice Hall
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CHAPTER OUTLINE
9
The Government and
Fiscal Policy
Government in the Economy
Government Purchases (G), Net Taxes (T), and Disposable
Income (Y
d
)
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 Economys 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 governments spending and taxing policies.
monetary policy The behavior of the Federal Reserve
concerning the nations money supply.
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discretionary fiscal policy Changes in taxes or spending that are the result
of deliberate changes in government policy.
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 (Y
d
) Total income minus net taxes:
Y T.
disposable income total income net taxes

Y
d
Y T
Government Purchases (G), Net Taxes (T), and Disposable Income (Y
d
)
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FIGURE 9.1 Adding Net Taxes
(T) and Government Purchases (G)
to the Circular Flow of Income
d
)
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The disposable income (Y
d
) of households must end up as either
consumption (C) or saving (S). Thus,
Y C S
d
+
Y T C S +
Y C S T + +
d
)
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).
G I C AE + +
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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
d
)
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To modify our aggregate consumption function to
incorporate disposable income instead of before-tax income,
instead of C = a + bY, we write
C = a + bY
d

or

C = a + b(Y T)
Our consumption function now has consumption depending
on disposable income instead of before-tax income.
d
)
Adding Taxes to the Consumption Function
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The government can affect investment behavior through its
tax treatment of depreciation and other tax policies.
d
)
Planned Investment
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Y = C + I + G
TABLE 9.1 Finding Equilibrium for I = 100, G = 100, and T = 100
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

Output
(Income)
Y

Net
Taxes
T

Disposable
Income
Y
d
Y T

Consumption
Spending
C = 100 + .75 Y
d

Saving
S
Y
d
C
Planned
Investment
Spending
I

Government
Purchases
G
Planned
Aggregate
Expenditure
C + I + G
Unplanned
Inventory
Change
Y (C + I + G)

Adjustment
to Disequi-
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 9.2 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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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
The Saving/Investment Approach to Equilibrium
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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
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1
government spending multiplier
MPS
=
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 9.2 Finding Equilibrium after a Government Spending Increase of 50 (G Has
Increased from 100 in Table 9.1 to 150 Here)
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

Output
(Income)
Y

Net
Taxes
T

Disposable
Income
Y
d
Y T

Consumption
Spending
C = 100 + .75 Y
d

Saving
S
Y
d
C
Planned
Investment
Spending
I

Government
Purchases
G
Planned
Aggregate
Expenditure
C + I + G
Unplanned
Inventory
Change
Y (C + I +
G)

Adjustment
to
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 Equilibrium
1,300 100 1,200 1,000 200 100 150 1,250 + 50 Output
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FIGURE 9.3 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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tax multiplier The ratio of change in the equilibrium level of output to
a change in taxes.
( )
tax multiplier
MPC
MPS

AY
MPS
=
|
\
|
.
| (initial increase in aggregate expenditure)
1
1
( )
MPC
Y T MPC T
MPS MPS
A = A = A
| | | |
| |
\ . \ .
The Tax Multiplier
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:
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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.
1 balanced-budget multiplier
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TABLE 9.3 Finding Equilibrium after a Balanced-Budget Increase in G and T of 200 Each
(Both G and T Have Increased from 100 in Table 9.1 to 300 Here)
(1) (2) (3) (4) (5) (6) (7) (8) (9)

Output
(Income)
Y

Net
Taxes
T

Disposable
Income
Y
d
Y T

Consumption
Spending
C = 100 + .75 Y
d

Planned
Investment
Spending
I

Government
Purchases
G
Planned
Aggregate
Expenditure
C + I + G
Unplanned
Inventory
Change
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 Equilibrium
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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TABLE 9.4 Summary of Fiscal Policy Multipliers

Policy Stimulus

Multiplier
Final Impact on
Equilibrium Y
Government
spending
multiplier
Increase or decrease in the
level of government
purchases: G
Tax multiplier Increase or decrease in the
level of net taxes: T
Balanced-budget
multiplier
Simultaneous balanced-budget
increase or decrease in the
level of government purchases
and net taxes: G = T

1
1
MPS
MPC
MPS
1
G
MPS
A

MPC
T
MPS
A
AG
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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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federal budget The 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.
The Federal Budget
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TABLE 9.5 Federal Government Receipts and Expenditures, 2009 (Billions of Dollars)
Amount Percentage of Total
Current receipts
Personal income taxes 828.7 37.2
Excise taxes and customs duties 92.3 4.1
Corporate income taxes 231.0 10.4
Taxes from the rest of the world 12.3 0.6
Contributions for social insurance 949.1 42.7
Interest receipts and rents and royalties 48.2 2.2
Current transfer receipts from business and persons 68.1 3.1
Current surplus of government enterprises 4.9 0.2
Total 2,224.9 100.0
Current Expenditures
Consumption expenditures 986.4 28.6
Transfer payments to persons 1596.1 46.2
Transfer payments to the rest of the world 61.7 1.8
Grants-in-aid to state and local governments 476.6 13.8
Interest payments 272.3 7.9
Subsidies 58.2 1.7
Total 3,451.3 100.0
Net federal government savingsurplus (+) or deficit ()
(Total current receipts Total current expenditures)

1,226.4
The Federal Budget
The Budget in 2009
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federal surplus (+) or deficit () Federal government receipts minus
expenditures.
The Federal Budget
The Budget in 2009
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FIGURE 9.4 Federal Personal Income Taxes as a Percentage of Taxable Income, 1993 I2010 I
The Federal Budget
Fiscal Policy Since 1993: The Clinton, Bush, and Obama Administrations
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FIGURE 9.5 Federal Government Consumption Expenditures as a Percentage of GDP and
Federal Transfer Payments and Grants-in-Aid as a Percentage of GDP, 1993 I2010 I
The Federal Budget
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FIGURE 9.6 The Federal Government Surplus (+) or Deficit () as a Percentage of GDP, 1993 I2010 I
The Federal Budget
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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.
The Federal Budget
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FIGURE 9.7 The Federal Government Debt as a Percentage of GDP, 1993 I2010 1
The Federal Budget
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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.
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.
The Economys Influence on the Government Budget
Automatic Stabilizers and Destabilizers
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.
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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 J ournal
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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.
The Economys Influence on the Government Budget
Full-Employment Budget
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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
policythe governments other major tool for influencing the economy.
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automatic destabilizers
automatic stabilizers
balanced-budget multiplier
budget deficit
cyclical deficit
discretionary fiscal policy
disposable, or after-tax, income (Y
d
)
federal budget
federal debt
federal surplus (+) or deficit ()
fiscal drag
fiscal policy
full-employment budget
government spending multiplier
monetary policy
net taxes (T)
privately held federal debt
structural deficit
tax multiplier
1. Disposable income Y
d
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
MPC
MPS
| |
|
\ .
MPS
1
R E V I E W T E R M S A N D C O N C E P T S
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Y C I G = + +
C a b Y T = + ( )
Y a b Y T I G = + + + ( )
Y a bY bT I G = + + +
Y bY a I G bT = + +
Y b a I G bT ( ) 1 = + +
( )
) (
1
1
bT G I a
b
Y + +
=
CHAPTER 9 APPENDIX A
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):
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It is easy to show formally that the balanced-budget multiplier = 1.
G A
increase in spending:
( ) C T MPC A = A
decrease in spending:
( ) G T MPC A A
= net increase in spending
In a balanced-budget increase, AG = AT; so we can substitute:
net initial increase in spending:
AG AG (MPC) = AG (1 MPC)
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1
( ) Y G MPS G
MPS
| |
A = A = A
|
\ .
Because MPS = (1 MPC), the net initial increase in spending is:
AG (MPS)
We can now apply the expenditure multiplier to this net initial
increase in spending:
|
.
|
\
|
MPS
1
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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T Y Y
d

) 3 / 1 200 ( Y Y Y
d
+
Y Y Y
d
3 / 1 200 +
d
Y C 75 . 100 + =
) 3 / 1 200 ( 75 . 100 Y Y C + + =
FIGURE 9B.1 The Tax Function
CHAPTER 9 APPENDIX B
The Case in Which Tax Revenues Depend on Income
This graph shows net taxes (taxes
minus transfer payments) as a
function of aggregate income.
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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.
FIGURE 9B.2 Different Tax Systems
G I C Y + + =
100 .75( 200 1/ 3 ) 100 100 Y Y Y
I G
C
= + + + +
450 5 .
5 . 450
100 100 25 150 75 . 100
=
+ =
+ + + + =
Y
Y Y
Y Y Y
The Case in Which Tax Revenues Depend on Income
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C a b Y T = + ( )
0
C a bY bT btY = +
0
( ) C a b Y T tY = +
0
Y a bY bT btY I G
C
= + + +
Y
b bt
a I G bT =
+
+ +
1
1
0
( )
The Government Spending and Tax Multipliers Algebraically
The Case in Which Tax Revenues Depend on Incomes
Through substitution we get
Solving for Y:
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1
1 b bt +
The Government Spending and Tax Multipliers Algebraically
The Case in Which Tax Revenues Depend on Incomes
This means that a $1 increase in G or I (holding a and T
0
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 T
0
) will
increase the equilibrium level of income by
bt b
b
+ 1

Macroeconomics: Case Fair Oster

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