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 The Government and Fiscal
Policy 24
CHAPTER
OUTLINE
Government in the Economy
Government Purchases (G), Net Taxes (T), and Disposable
Income (Yd)
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 2012
Fiscal Policy Since 1993: The Clinton, Bush, and Obama
Administrations
The Federal Government Debt
The Economy’s 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 government’s spending and taxing policies.

monetary policy The behavior of the Federal Reserve concerning the nation’s
money supply.

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 Government in the Economy

discretionary fiscal policy Changes in taxes or spending that are the result of
deliberate changes in government policy.

Government Purchases (G), Net Taxes (T), and Disposable Income (Yd)

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 (Yd) Total income minus net taxes: Y − T.

disposable income ≡ total income − net taxes

Yd ≡ Y − T

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  FIGURE 24.1 Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow
of Income

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 The disposable income (Yd) of households must end up as either consumption
(C) or saving (S). Thus,

Yd  C  S
Because disposable income is aggregate income (Y) minus net taxes (T), we
can write another identity:

Y T C S
By adding T to both sides:

Y CS T
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).

AE  C  I  G
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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

Adding Taxes to the Consumption Function

To modify our aggregate consumption function to incorporate disposable

income instead of before-tax income, instead of C = a + bY, we write

C = a + bYd

or

C = a + b(Y − T)

Our consumption function now has consumption depending on disposable

income instead of before-tax income.
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 Planned Investment

The government can affect investment behavior through its tax treatment of
depreciation and other tax policies.

Planned investment depends on the interest rate, both of which we continue to

assume are fixed for purposes of this chapter.

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 The Determination of Equilibrium Output (Income)

Y=C+I+G

TABLE 24.1 Finding Equilibrium for I = 100, G = 100, and T = 100

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

Planned Planned Unplanned

Output Net Disposable Consumption Saving Investment Government Aggregate Inventory Adjustment
(Income) Taxes Income Spending S Spending Purchases Expenditure Change to Disequi-
Y T Yd ≡Y −T C = 100 + .75 Yd Yd – C I G C + I + G Y − (C + I + G) 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 24.2 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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 The Saving/Investment Approach to Equilibrium

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

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 Fiscal Policy at Work: Multiplier Effects
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

The Government Spending Multiplier

1 1
government spending multiplier  
MPS 1  MPC

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 24.2 Finding Equilibrium after a Government Spending Increase of 50 (G Has
Increased from 100 in Table 24.1 to 150 Here)
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
Unplanned
Planned Planned Inventory
Output Net Disposable Consumption Saving Investment Government Aggregate Change Adjustment
(Income) Taxes Income Spending S Spending Purchases Expenditure Y − (C + I + to
Y T Yd ≡Y −T C = 100 + .75 Yd Yd – C I G C+I+G G) 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 24.3 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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 The Tax Multiplier

tax multiplier The ratio of change in the equilibrium level of output to a change
in taxes.

 1 
Y  (in itial increase in ag g reg ate ex pen diture)   
 M PS 

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:

 1   MPC 
Y  (  T  MPC )     T   
 MPS   MPS 
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:

tax multiplier    
MPC

MPS
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 The Balanced-Budget Multiplier

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.

balanced-budget multiplier  1

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 TABLE 24.3 Finding Equilibrium after a Balanced-Budget Increase in G and T of 200 Each
(Both G and T Have Increased from 100 in Table 24.1 to 300 Here)
(1) (2) (3) (4) (5) (6) (7) (8) (9)

Planned Planned Unplanned

Output Net Disposable Consumption Investment Government Aggregate Inventory Adjustment
(Income) Taxes Income Spending Spending Purchases Expenditure Change to
Y T Y d ≡Y − T C = 100 + .75 Yd I G C + I + G Y − (C + I + G) 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 24.4 Summary of Fiscal Policy Multipliers
Final Impact on
Policy Stimulus Multiplier Equilibrium Y
Government Increase or decrease in the 1 1
spending level of government G 
multiplier purchases: ∆G
M PS MPS

Tax multiplier Increase or decrease in the  M PC  MPC

level of net taxes: ∆T T 
M PS MPS

Balanced- Simultaneous balanced-budget

budget increase or decrease in the 1 G
multiplier level of government
purchases and
net taxes: ∆G = ∆T

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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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 The Federal Budget

Because fiscal policy is the manipulation of items in the federal budget, that
budget is relevant to our study of macroeconomics.

federal budget The budget of the federal government.

An enormously complicated document up to thousands of pages each year, the

federal budget lists in detail all the things the government plans to spend
money on and all the sources of government revenues for the coming year.

It is the product of a complex interplay of social, political, and economic forces.

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 The Budget in 2012
TABLE 24.5 Federal Government Receipts and Expenditures, 2012 (Billions of Dollars)
Amount Percentage of Total
Current receipts
Personal income taxes 1,137.8 42.5
Excise taxes and customs duties 116.1 4.3
Corporate income taxes 373.7 14.0
Taxes from the rest of the world 17.3 0.6
Contributions for social insurance 934.8 35.0
Interest receipts and rents and royalties 53.4 2.0
Current transfer receipts from business and persons 59.2 2.2
Current surplus of government enterprises − 17.8 − 0.7
Total 2,674.5 100.0
Current expenditures
Consumption expenditures 1,059.6 28.2
Transfer payments to persons 1,773.2 47.2
Transfer payments to the rest of the world 76.4 2.0
Grants-in-aid to state and local governments 468.0 12.5
Interest payments 318.5 8.5
Subsidies 60.4 1.6
Total 3,756.1 100.0
Net federal government saving–surplus (+) or deficit (−)
(Total current receipts − Total current expenditures) − 1,081.6

federal surplus (+) or deficit (−) Federal government receipts minus

expenditures.
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 Fiscal Policy Since 1993: The Clinton, Bush, and Obama Administrations

 FIGURE 24.4 Federal Personal Income Taxes as a Percentage of Taxable Income, 1993 I–2012
IV

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  FIGURE 24.5 Federal Government Consumption Expenditures as a Percentage of GDP and
Federal Transfer Payments and Grants-in-Aid as a Percentage of GDP, 1993 I–2012 IV

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  FIGURE 24.6 The Federal Government Surplus (+) or Deficit (−) as a Percentage of
GDP, 1993 I–2012 IV

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 ECONOMICS IN PRACTICE

The U.S. Congress Fights about the Budget

In January 2013, Congress signed the American Tax Relief Act (ATRA), which
retained many of the earlier Bush tax cuts, while modifying others. But the
specter of automatic spending cuts remained.
In the spring of 2013, arguments about the shape of the 2014 budget were
raging, as members of the House commented on a budget proposal of Paul
Ryan, Republican Congressman from Wisconsin.
Representative Eddie Bernice Johnson of Texas, a Democrat, had this to say
about Congressman Ryan’s bill: “This budget would not only jeopardize seniors,
families and the most vulnerable in our society, it would also destroy jobs and
put our nation’s economic recovery at risk.”
The Congress heard a different view from Andy Barr, a new Republican
Congressman from Kentucky: “Families and small businesses should be able to
keep more of their hard-earned income instead of having it wasted by
Washington bureaucrats.”

THINKING PRACTICALLY
1.How would you describe the views of the two people quoted on the benefits of
government spending?
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 The Federal Government Debt

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.

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  FIGURE 24.7 The Federal Government Debt as a Percentage of GDP, 1993 I–2012 IV

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 ECONOMICS IN PRACTICE

The Debt Clock

Next time you are in New York City, wander by West 44th Street and the
Avenue of the Americas.

Located on an outside wall is a U.S. Debt Clock, mounted by Seymour Durst, a

N.Y. real estate developer.

Rather than showing us the passage of time, as would a conventional clock,

this clock shows us the mounting of the U.S. debt.

Durst was an early worrier about the debt! Needless to say, it sped up during
the Obama administration. See Figure 24.7.

THINKING PRACTICALLY
1.For a few years beginning in 2000, the clock was stopped and covered up.
Can you guess why based on the data you have seen in this chapter?
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 The Economy’s Influence on the Government Budget

Automatic Stabilizers and Destabilizers

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.

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.

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.

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 Full-Employment Budget

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.

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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
policy—the government’s other major tool for influencing the economy.

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 REVIEW TERMS AND CONCEPTS

automatic destabilizers privately held federal debt

automatic stabilizers structural deficit
balanced-budget multiplier tax multiplier
budget deficit Disposable income Yd ≡ Y − T
cyclical deficit AE ≡ C + I + G
discretionary fiscal policy Government budget deficit ≡ G − T
disposable, or after-tax, income (Yd) Equilibrium in an economy with a
federal budget government: Y = C + I + G
federal debt Saving/investment approach to
equilibrium in an economy with a
federal surplus (+) or deficit (−)
government: S + T = I + G
fiscal drag
Government spending multiplier
fiscal policy 1 1
 
full-employment budget MPS 1  MPC

government spending multiplier  MPC 


7. Tax multiplier ≡  
monetary policy  MPS 
net taxes (T) 8. Balanced-budget multiplier ≡ 1
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 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:
C  a  b (Y  T )
The equilibrium condition is
Y CI G
By substituting for C, we get
Y  a  b (Y  T )  I  G
Y  a  bY  b T  I  G
This equation can be rearranged to yield
Y  bY  a  I  G  bT
Y (1  b )  a  I  G  b T
Now solve for Y by dividing through by (1 − b):
1
Y  (a  I  G  bT )
1  b 
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 The Balanced-Budget Multiplier

It is easy to show formally that the balanced-budget multiplier = 1.

initial increase in spending: G

− initial decrease in spending: C  T ( MPC )
= net initial increase in spending G  T ( MPC )

In a balanced-budget increase, ∆G = ∆T; so in the above equation for the

net initial increase in spending we can substitute ∆G for ∆T.

∆G − ∆G (MPC) = ∆G (1 − MPC)

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

∆G (MPS)

 1 
We can now apply the expenditure multiplier   to this net initial
increase in spending:  MPS 

 1 
Y  G ( MPS )    G
 MPS 

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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 CHAPTER 9 APPENDIX B
The Case in Which Tax Revenues Depend on Income
 FIGURE 9B.1 The Tax Function
This graph shows net taxes
(taxes minus transfer
payments) as a function of
aggregate income.

Yd  Y  T

Yd  Y  (200  1 / 3Y )

Yd  Y  200  1 / 3Y

C  100  .75Yd

C  100  .75(Y  200  1 / 3Y )

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 Y C  I G

Y  100  .75(Y  200  1/ 3Y )  100

  100

         
C I G

Y  100  .75Y  150  25Y  100  100

Y  450  .5Y
.5Y  450

 FIGURE 9B.2 Different Tax

Systems

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.

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 The Government Spending and Tax Multipliers Algebraically

C  a  b (Y  T )

C  a  b(Y  T0  tY )

C  a  bY  bT0  btY

We know that Y = C + I + G. Through substitution we get

Y  a  bY  bT  btY  I  G
      
0

C
Solving for Y:

1
Y  ( a  I  G  bT 0 )
1  b  bt
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 This means that a $1 increase in G or I (holding a and T0 constant) will increase
the equilibrium level of Y by

1
1  b  bt

Holding a, I, and G constant, a fixed or lump-sum tax cut (a cut in T0) will
increase the equilibrium level of income by

b
1  b  bt

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