CASE FAIR - 22 sd 25.rar

  Chapter

  22 _{and Fiscal Policy} The Government Prepared by: _{Fernando & Yvonn Quijano}

  C H A P T E R

   2 2: T h e G ov er n m en t an d F is ca l P ol ic y _{Chapter Outline}

  22 The Government

and Fiscal Policy

  Government in the Economy _{Government Purchases ( G), Net Ta xes (T), and Disposable income ( Y d ) Equilibrium Output: Y = C + I + G} Fiscal Policy at Work: Multiplier Effects _{The Government Spending Multiplier The Ta x Multiplier The Balanced-Budget Multiplier} The Federal Budget _{The Budget The Surplus or Deficit The Debt} The Economy’s Influence on the Government _{Budget Ta x Revenues Depend on the State of the Economy Some Government Expenditures Depend on the} State of the Economy _{Automatic Stabilizers Fiscal Drag Full-Employment Budget} Looking Ahead _{Appendix A: Deriving the Fiscal Policy Multipliers Appendix B: The Case in Which Ta x Revenues}

  Y Y T d

  ≡ −

  _{and taxing policies.} fiscal policy The government’s spending

  t y ic en ol m n l P er monetary policy The behavior of the ca ov is _{Federal Reserve concerning the nation’s}

  G F d e _{money supply.} h an T 2:

   2 R E T P A H C discretionary fiscal policy Changes in

  t y _{taxes or spending that are the result of} ic en ol _{deliberate changes in government} m n l P _policy. er ca ov is G F d e h an T 2:

   2 R E T P A H C

  _{AND DISPOSABLE INCOME ( )}

GOVERNMENT PURCHASES ( ), NET TAXES ( ),

_{Y D G T}

  t y ic en ol _{net taxes ( Ta xes paid by firms and} m ^T) n l P _{households to the government minus} er ca ov is _{transfer payments made to households}

  G F d e _{by the government.} h an T 2:

   2 R E T P A H C

  t y ic en ol m n l P er ca ov is G F d e h an T 2:

   2 R E T P A H C _{FIGURE 9.1 Adding Net Ta xes ( ) and Government Purchases ( ) to the Circular Flow of Income T G}

  _{To tal income minus net taxes:}

disposable, or after-tax, income ( )

_{Y T. Y d} −

  t y ic en ol m n _{disposable income total income net taxes}

  ≡ −

  l P er ca ov is _{Y d} ≡ Y − T G F d e h an T 2:

   2 R E T P A H C

  When government enters the picture, the aggregate _{income identity gets cut into three pieces:}

  t y ic en ol m n l P er ca ov is G F d e h an T 2:

   2 R E T _{And aggregate expenditure ( AE) equals:} P A H C budget deficit The difference between

  t y _{what a government spends and what it} ic en ol m _{collects in taxes in a given period: G T.}

  −

  n l P er ca ov is G F _{budget deficit}

  ≡ G − T

  d e h an T 2:

   2 R E T P A H C

  Adding Ta xes to the Consumption Function

  t To modify our aggregate consumption function to y ic en _{incorporate disposable income instead of before-} ol m _{tax income, instead of = , we write} n ^{C a bY} l P

• ⁺ er ca ov is G F d e
_{C = a bY d +} h an T _or

  2: _{C a b Y T = ( )}

• ⁺ 2

  −

  R E T _{Our consumption function now has consumption} P A _{depending on disposable income instead of before-}

  H C _{tax income.}

  Investment

  t y The government can affect investment behavior ic en _{through its tax treatment of depreciation and other} ol m n _{tax policies.} l P er ca ov is G F d e h an T 2:

   2 R E T P A H C

  EQUILIBRIUM OUTPUT: Y = C _{equilibrium condition: Y = C + I + G} ^{I + + G}

  t y ic en ol m _{TABLE 9.1 Finding Equilibrium for (All Figures in Billions of Dollars) I = 100, G = 100, and T = 100} n l P er ca ov is _{(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)}

  G F d e h _{DISPOSABLE INCOME CONSUMPTION SAVING PLANNED PLANNED UNPLANNED INVENTORY} an OUTPUT NET _{(INCOME) TAXES Y T Y ( C = 100 + .75 Y ) d  T d d  Y SPENDING S – ( Y C)} ^{INVESTMENT GOVERNMENT AGGREGATE CHANGE ADJUSTMENT} _{SPENDING PURCHASES EXPENDITURE TO I G C + I + G Y  (C + I + G) DISEQUILIBRIUM} T 2: _{300 100 200 250 100 100 450  50  150 Output }

   2 _{500 100 400 400 100 100 600} R ^{ 100 Output} _

  E 700 100 600 550 ^{50 100 100 750} _{ 50 Output } T _{900 100 800 700 100 100 100 900 Equilibrium}

  P _{1,100 100 1,000 850 150 100 100 1,050 + 50} A _{1,300 100 1,200 1,000 200 100 100 1,200 + 100 Output }

  H _{Output } C _{1,500 100 1,400 1,150 250 100 100 1,350 + 150 Output }

  t y ic en ol m n l P er ca ov is G F d e h an T 2:

   2 R E T P A H C _{FIGURE 9.2 Finding Equilibrium Output/Income Graphically}

  The Leakages/Injections Approach to Equilibrium

Ta xes ( T) are a leakage from the flow of income. Saving

  t y ic _{( S) is also a leakage.} en ol m n l P er ca _{In equilibrium, aggregate output (income) ( Y) equals} ov is G planned aggregate expenditure ( _{AE), and leakages (S + T)}

   F d e _{must equal planned injections (} h ^{I + G). Algebraically,} an T 2:

   2 R E T P A H C _{leakages/injections approach to equilibrium: S + T = I + G}

TABLE 9.2 Finding Equilibrium After a $50 Billion Government Spending Increase (All THE GOVERNMENT SPENDING MULTIPLIER 150 Here) Figures in Billions of Dollars; G Has Increased from 100 in Ta ble 9.1 to

  t y ic en ol m n l P (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) er ca ov is _{OUTPUT NET DISPOSABLE INCOME CONSUMPTION SAVING INVESTMENT GOVERNMENT AGGREGATE CHANGE ADJUSTMENT PLANNED PLANNED UNPLANNED INVENTORY} G _{(INCOME) TAXES} ^{SPENDING S} _{SPENDING PURCHASES EXPENDITURE TO –}

   F _{Y T  T Y ( C = 100 + .75 Y ) ( Y d d d  Y C) I G C + I + G  (C + I + G) DISEQUILIBRIUM Y} d e h _{300 100 200 250 100 150 500} an _{ 50  200 Output }

   T _{500 100 400 400 100 150 650  150 Output} 2: ^

   2 _{700 100 600 550 50 100 150 800  100 Output } R E _{900 100 800 700 100 100 150 950  50 Output }

  T P _{1,100 100 1,000 850 150 100 150 1,100 Equilibrium} A _{1,300 100 1,200 1,000 200 100 150 1,250 + 50}

  H _{Output } C

  t y ic en ol m n l P er ca _{government spending multiplier The} ov is _{ratio of the change in the equilibrium} G _{level of output to a change in}

   F d government spending. e h an T 2:

   2 R E T P A H C

  t y ic en ol m n l P er ca ov is G F d e h an T 2:

   2 R E T P A H C _{FIGURE 9.3 The Government Spending Multiplier}

  t y

  The multiplier for a change in taxes is not the same as the multiplier for a change in

  ic en ol government spending. m n l P er ca ov is _{tax multiplier The ratio of change in} G F d e _{the equilibrium level of output to a} h an T _{change in taxes.} 2:

   2 R E T P A H C

  t y ic en ol m n l P er ca ov is G F d e h an T 2:

   2 R E T P A H C balanced-budget multiplier The ratio of

  t y _{change in the equilibrium level of} ic en ol m _{output to a change in government} n l P er _{spending where the change in} ca ov is _{government spending is balanced by a}

  G F d e _{change in taxes so as not to create any} h an T _{deficit. The balanced-budget multiplier}

  2:

   2 _{is equal to 1: The change in Y} R E _{resulting from the change in G and the}

  T P _{equal change in T is exactly the same} A H _{size as the initial change in G or T}

  C _itself.

  t y ic en ol m n l P er ca ov is G F d e h an T 2:

   2 R E

  An increase in government spending has a direct initial effect on planned aggregate

  T P expenditure; a tax increase does not. The initial effect of the tax increase is that A

  households cut consumption by the MPC times the change in taxes. This change in

  H

  consumption is less than the change in taxes, because the MPC is less than 1. The

  C

  positive stimulus from the government spending increase is thus greater than the negative stimulus from the tax increase. The net effect is that the balanced-budget multiplier is 1.

TABLE 9.3 Finding Equilibrium After a $200-Billion Balanced-Budget Increase in from 100 in Ta ble 9.1 to 300 Here) and T (All Figures in Billions of Dollars; Both G and T Have Increased G

  t y _{(1) (2) (3) (4) (5) (6) (7) (8) (9)} ic en ol m _UNPLANNED n _{DISPOSABLE PLANNED PLANNED CONSUMPTION INVENTORY} l P _{(INCOME) TAXES SPENDING PURCHASES EXPENDITURE TO OUTPUT NET Y T Y Y ( C = 100 + .75 Y )} ^INCOME _{d  T d SPENDING INVESTMENT GOVERNMENT AGGREGATE ADJUSTMENT I G C + I + G DISEQUILIBRIUM Y  (C + I + G)} ^CHANGE er ca ov is _{500 300 200 250 100 300 650  150 Output }

  G F d e _{700 300 400 400 100 300 800  100 Output } h an _{900 300 600 550 100 300 950}

   T _{ 50} ^Output _ 2: _{1,100 300 800 700 100 300 1,100 Equilibrium}

   2 R _{1,300 300 1,000 850 100 300 1,250 + 50 Output } E T _{1,500 300 1,200 1,000 100 300 1,400 + 100 Output }

  P A H C

TABLE 9.4 Summary of Fiscal Policy Multipliers POLICY STIMULUS MULTIPLIER EQUILIBRIUM Y FINAL IMPACT ON

  t y ic _{Government- Increase or decrease in the} en _{spending level of government} ol _{multiplier purchases:} m n l P er ca ov is G F d e _{Ta x multiplier Increase or decrease in the} h _{level of net taxes:} an

   T 2:

   2 R E Balanced- Simultaneous balanced-budget _{budget increase or decrease in the} T _{multiplier level of government purchases and net taxes:}

  P

  1 A

  H C

  _government. federal budget The budget of the federal

  t y ic en ol m n l P er ca ov is G F d e h an T 2:

   2 R E T P A H C

TABLE 9.5 Federal Government Receipts and Expenditures, 2004 (Billions of Dollars) THE BUDGET Receipts

  _{AMOUNT OF TOTAL} PERCENTAGE

  t y ic _{Personal income taxes 801.8 40.6} en ol _{Excise taxes and custom duties 94.0 4.8} m n Corporate income taxes ^{217.4 11.0} l P _{Ta xes from the rest of the world 9.2 0.5} er ca _{Contributions for social insurance 802.5 40.6} ov is _{Interest receipts and rents and royalties 21.9 1.1} G

   F _{Current transfer receipts from business and persons 28.6 1.4} d e h _{Current surplus of government enterprises 0.5 0.0}

  −

  an _{To tal 1,974.8 100.0} T _{Current Expenditures}

  2: _{Consumption expenditures 725.7 30.5}

   2 _{Transfer payments to persons 1,014.0 42.6} R _{Transfer payments to the rest of the world 28.9 1.2} E _{Grants-in-aid to state and local governments 348.3 14.6} T P _{Interest payments 221.5 9.3} A _{Subsidies 43.0 1.8} H _{To tal 2,381.3 100.0}

  C _{Net federal government saving—surplus (+) or deficit ( ) (total current receipts total current expenditures) −}

  − _{406.5 Source: U.S. Department of Commerce, Bureau of Economic Analysis.} − THE SURPLUS OR DEFICIT _{federal surplus (+) or deficit ( ) Federal} −

  t y _{government receipts minus expenditures.} ic en ol m n l P er ca ov is G F d e h an T 2:

   2 R E T P A H C _{FIGURE 9.4 The Federal Government Surplus (+) or Deficit ( ) as a Percentage of GDP, 1970 I–2005 II} −

  t y _{federal debt The total amount owed} ic en ol m _{by the federal government.} n l P er ca ov is G F _{privately held federal debt The} d e h an privately held (nongovernment-

   T _{owned) debt of the U.S. government.} 2:

   2 R E T P A H C

  t y ic en ol m n l P er ca ov is G F d e h an T 2:

   2 R E T P A _{FIGURE 9.5 The Federal Government Debt as a Percentage of GDP, 1970 I–2005 II} H C

  _ECONOMY TAX REVENUES DEPEND ON THE STATE OF THE

  t y ic en ol m n l P _{Ta x revenue depends on taxable income, and} er ca _{income depends on the state of the economy,} ov is

  G F which the government does _{not control.} d e h an T 2:

   2 R E T P A H C

  _{ON THE STATE OF THE ECONOMY} SOME GOVERNMENT EXPENDITURES DEPEND

  t y ic en ol m _{Transfer payments tend to go down} n l P _{automatically during an expansion.} er ca ov is G F _{Inflation often picks up when the economy is} d e h _{expanding. This can lead the government to} an

   T _{spend more than it had planned to spend.} 2:

   2 R E T P _{Any change in the interest rate changes} A H government interest payments. C

  t y _{automatic stabilizers Revenue and} ic en ol m _{expenditure items in the federal} n l P er _{budget that automatically change} ca ov is _{with the state of the economy in}

  G F d e h such a way as to stabilize GDP. an T 2:

   2 R E T P A H C

  t y _{fiscal drag The negative effect on} ic en ol m _{the economy that occurs when} n l P er _{average tax rates increase because} ca ov is _{taxpayers have moved into higher}

  G F d e _{income brackets during an} h an T _expansion. 2:

   2 R E T P A H C full-employment budget What the

  t y ic en _{federal budget would be if the} ol m n l P _{economy were producing at a full-} er ca _{employment level of output.} ov is G F d e h an _{structural deficit The deficit that}

   T 2: _{remains at full employment.}

   2 R E T _{cyclical deficit The deficit that} P A _{occurs because of a downturn in the}

  H C _{business cycle.}

  _{balanced-budget automatic stabilizers structural deficit privately held federal debt} net taxes ( _{T) budget deficit} multiplier _{tax multiplier}

  t y _{1. Disposable income Yd T cyclical deficit}

  ic en ol _2. m ^AE _{discretionary fiscal policy} ≡ C + I + G n l P _{disposable, or after-tax, 3. Government budget deficit T}

  ≡ Y −

  er ca _{4. Equilibrium in an economy with} ov is _{income ( ) Y d} G F _{federal budget government: Y = C + I + G} d e h _{5. Leakages/injections approach to} an _{federal debt}

  ≡ G −

   T _{federal surplus (+) or equilibrium in an economy with} 2:

   2 _{deficit ( ) government: S + T = I + G}

  −

  R E ^{6. Government spending multiplier} _{fiscal drag}

  ≡

  T P _{fiscal policy} A _{7. Ta x multiplier full-employment budget} ≡

  H C _{government spending multiplier 8. Balanced-budget multiplier 1 monetary policy}

  ≡ DERIVING THE FISCAL POLICY MULTIPLIERS _{THE GOVERNMENT SPENDING AND TAX} MULTIPLIERS

  t y ic en ol m n l P er ca ov is G F d e h an T 2:

   2 R E T P A H C

  THE BALANCED-BUDGET MULTIPLIER

_{The balanced-budget multiplier is found by combining}

  t the effects of government spending and taxes: y ic en ol m n l P _{increase in spending:} er ca

• _{- decrease in} ov is _spending:

  G F = net increase in spending d e h an T _{In a balanced-budget increase, G = T, so we can}

  2:

  Δ Δ

   2 _substitute: R E T P _{net initial increase in spending:}

  A H ^{G G (MPC) = G (1 MPC)}

  Δ − Δ Δ −

  C

  Because _{MPS = (1 MPC), the net initial increase in spending is:} −

  t y _{G (MPS)} ic

  Δ

  en ol m n l P er ca _{We can now apply the expenditure multiplier} ov is _{to this net initial increase in spending:} G F d e h an T 2:

   2 R E T P A H C

  _INCOME THE CASE IN WHICH TAX REVENUES DEPEND ON

  t y ic en ol m n l P er ca ov is G F d e h an T 2:

   2 R E T P A H C _{FIGURE 9B.1 The Ta x Function}

  t y ic en ol m n l P er ca ov is G F d e h an T 2:

   2 R E T P A H C _{FIGURE 9B.2 Different Ta x Systems}

  _{MULTIPLIERS ALGEBRAICALLY} THE GOVERNMENT SPENDING AND TAX

  t y ic en ol m n l P er ca ov is G F d e h an T 2:

   2 R E T P A H C