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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 Quijano
and 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 as
the role of government in the economy.
Government can affect the macroeconomy
in two ways:
Fiscal policy is the manipulation of
government spending and taxation.
Monetary policy refers to the behavior of the
Federal Reserve regarding the nations money
supply.


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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 3 of 35
Government in the Economy
Discretionary fiscal policy refers to
deliberate changes in taxes or spending.
The government can not control certain
aspects of the economy related to fiscal
policy. For example:
The government can control tax rates but not
tax revenue. Tax revenue depends on
household income and the size of corporate
profits.
Government spending depends on government
decisions and the state of the economy.


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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 4 of 35
Net Taxes (T), and Disposable Income (Y
d
)
Net taxes are 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
) equals total income minus
taxes.
Y Y T
d



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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 5 of 35
The Budget Deficit
A governments budget deficit is the
difference between what it spends (G) and
what it collects in taxes (T) in a given
period:
Budget def G T icit
If G exceeds T, the government must
borrow from the public to finance the
deficit. It does so by selling Treasury
bonds and bills. In this case, a part of
household saving (S) goes to the
government.


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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 6 of 35
Adding Taxes to the
Consumption Function
The aggregate consumption function
is now a function of disposable, or
after-tax, income.
C a bY
d
= +
Y Y T
d

C a b Y T = + ( )


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

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 50 100 100 450 150
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 Y
d
= + 100 75 . C Y T = + 100 75 . ( )


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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 8 of 35
The Government Spending Multiplier
The government spending
multiplier is the ratio of the change
in the equilibrium level of output to a
change in government spending.
Government multiplier
MPS
spending =
1


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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 9 of 35
The Government Spending Multiplier
Finding Equilibrium After a $50 Billion Government Spending Increase
(All Figures in Billions of Dollars; G Has Increased From 100 in Table 25.1 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
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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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 10 of 35
The Government Spending Multiplier


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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 11 of 35
The Tax Multiplier
A tax cut increases disposable
income, and leads to added
consumption spending. Income will
increase by a multiple of the
decrease in taxes.
A tax cut has no direct impact on
spending. The multiplier for a
change in taxes is smaller than the
multiplier for a change in government
spending.


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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 12 of 35
The Tax Multiplier
AY
MPS
=
|
\

|
.
| (initial increase in aggregate expenditure)
1
A A A Y T MPC
MPS
T
MPC
MPS
=
|
\

|
.
| =
|
\

|
.
| ( )
1
Tax multip
MPC
MPS
lier
|
\

|
.
|


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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 13 of 35
The Balanced-Budget Multiplier
The balanced-budget multiplier is
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.


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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 14 of 35
The Balanced-Budget Multiplier
Finding Equilibrium After a $200 Billion Balanced Budget Increase in G and T
(All Figures in Billions of Dollars; G and T Have Increased From 100 in Table 25.1 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
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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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 15 of 35
Fiscal Policy Multipliers
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:
Tax multiplier Increase or decrease in the
level of net taxes:
Balanced-
budget
multiplier
Simultaneous balanced-budget
increase or decrease in the
level of government purchases
and net taxes:

1
1
MPS
MPC
MPS
AG
MPS

1
AT
MPC
MPS

AG


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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 16 of 35
The Federal Budget
The federal budget is the budget of
the federal government.
The difference between the federal
governments receipts and its
expenditures is the federal surplus
(+) or deficit (-).


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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 17 of 35
The Federal Budget
Federal Government Receipts and Expenditures, 2000 (Billions of Dollars)

AMOUNT
PERCENTAGE
OF TOTAL
Receipts
Personal taxes 1,010.1 49.6
Corporate taxes 193.2 9.5
Indirect business taxes 111.0 5.5
Contributions for social insurance 720.6 35.4
Total 2,034.9 100.0
Current Expenditures
Consumption 514.1 26.9
Transfer payments 831.9 43.6
Grants-in-aid to state and local governments 274.2 14.4
Net interest payments 236.9 12.4
Net 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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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 18 of 35
The Federal Government Surplus (+) or
Deficit (-) as a Percentage of GDP, 1970 I2003 II


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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 19 of 35
The Debt
The federal debt is the total amount
owed by the federal government. The
debt is the sum of all accumulated
deficits minus surpluses over time.
Some of the federal debt is held by
the U.S. government itself and some
by private individuals. The privately
held federal debt is the private (non-
government-owned) portion of the
federal debt.


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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 20 of 35
The Federal Government Debt as a
Percentage of GDP, 1970 I2003 II
The percentage began to fall in the mid 1990s.


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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 21 of 35
The Economys Influence
on the Government Budget
Automatic stabilizers are
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.



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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 22 of 35
The Economys Influence
on the Government Budget
Fiscal drag is 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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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 23 of 35
The Economys Influence
on the Government Budget
The full-employment budget
is what the federal budget
would be if the economy were
producing at a full-employment
level of output.


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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 24 of 35
The Economys Influence
on the Government Budget
The cyclical deficit is the
deficit that occurs because of a
downturn in the business cycle.
The structural deficit is the
deficit that remains at full
employment.