Chapter 9: The Government and Fiscal Policy

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Chapter 9 The Governmentand Fiscal Policy
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Outline

• I. Government in the economy
• II. How fiscal policy works? Multiplier effects.
• 1. The government spending multiplier
• 2. The tax multiplier
• 3. The balanced-budget multiplier
• III. The federal budget
• IV. The economys influence on the government
  budget

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I. Government in the Economy

• Government can affect the macroeconomy in two
  ways
• Fiscal policy
• Monetary policy

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I. 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.

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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

• 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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Disposable Income (Yd)

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

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Adding Net Taxes (T) and Government Purchases (G)
to the Circular Flow of Income

• When government enters the picture, the aggregate
  income identity gets cut into three pieces

• And aggregate expenditure (AE) equals

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Adding Taxes to theConsumption Function

• The aggregate consumption function is now a
  function of disposable, or after-tax, income.

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Equilibrium Output Y C I G
Finding Equilibrium aggregate output for I 100,
G 100, and T 100 (All Figures in Billions of
Dollars)
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Finding EquilibriumOutput/Income Graphically
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The Leakages/Injections Approach

• Taxes (T) are a leakage from the flow of income.
  Saving (S) is also a leakage.
• In equilibrium, aggregate output (income) (Y)
  equals planned aggregate expenditure (AE), and
  leakages (S T) must equal planned injections (I
  G). Algebraically,

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Adding Net Taxes (T) and Government Purchases (G)
to the Circular Flow of Income
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II. 1. 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.

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II. 1. The Government Spending Multiplier
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II. 1. The Government Spending Multiplier
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II. 2. 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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II. 2. The Tax Multiplier
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II. 3. 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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II. 3. The Balanced-Budget Multiplier
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Fiscal Policy Multipliers
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III. 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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III. The Federal Budget
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The Federal Government Surplus () or Deficit
(-) as a Percentage of GDP, 1970 I-2003 II
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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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The Federal Government Debt as a Percentage of
GDP, 1970 I-2003 II

• The percentage began to fall in the mid 1990s.

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IV. The Economys Influenceon 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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IV. The Economys Influenceon 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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IV. The Economys Influenceon 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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IV. The Economys Influenceon 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.

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Review Terms and Concepts

• automatic stabilizers
• balanced-budget multiplier
• budget deficit
• cyclical deficit
• discretionary fiscal policy
• disposable, or after-tax, income
• federal budget
• federal debt
• federal surplus () or deficit (-)

• fiscal drag
• fiscal policy
• full-employment budget
• government spending multiplier
• monetary policy
• net taxes
• privately held federal debt
• structural deficit
• tax multiplier