CH 09

PRINCIPLES OF
MACROECONOMICS
TENTH EDITION
PART III The Core of Macroeconomic Theory
CASE FAIR OSTER

© 2012 Pearson Education, Inc. Publishing as Prentice Hall Prepared by: Fernando Quijano & Shelly
1 ofTefft
42
© 2012 Pearson Education, Inc. Publishing as Prentice Hall 2 of 42

The Government and Fiscal
Policy 9
CHAPTER
OUTLINE in the Economy
Government
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 2009
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
fiscal policy The government’s spending and taxing policies.
monetary policy The behavior of the Federal Reserve

concerning the nation’s money supply.

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

 FIGURE 9.1 Adding Net Taxes

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

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
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.

Planned Investment
The government can affect investment behavior through its

tax treatment of depreciation and other tax policies.

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)
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 Y d ≡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 ↓

 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.

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
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

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.

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)
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 ↑
 150
500 100 400 400 0 100 150 650 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 ↓

 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.

The Tax Multiplier
tax multiplier The ratio of change in the equilibrium level of output to

a change in taxes.
 1 
Y  (in itial in crease in ag g reg ate ex p en d itu re)   
 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:

Y  (  T  MPC )  
1   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  
© 2012 Pearson Education, Inc. Publishing as Prentice Hall

 MPC
MPS
18 of 42
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

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)
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 ↓

TABLE 9.4 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
 M PC  MPC
Tax multiplier Increase or decrease in the T 

level of net taxes: ∆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

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.

The Federal Budget
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
The Budget in 2009
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 saving—surplus (+) or deficit (−)
(Total current receipts − Total current expenditures) − 1,226.4

The Federal Budget
The Budget in 2009
federal surplus (+) or deficit (−) Federal government receipts minus

expenditures.

The Federal Budget
Fiscal Policy Since 1993: The Clinton, Bush, and Obama Administrations
 FIGURE 9.4 Federal Personal Income Taxes as a Percentage of Taxable Income, 1993 I–2010 I

The Federal Budget
 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 I–2010 I

The Federal Budget
 FIGURE 9.6 The Federal Government Surplus (+) or Deficit (–) as a Percentage of GDP, 1993 I–2010 I

The Federal Budget
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

 FIGURE 9.7 The Federal Government Debt as a Percentage of GDP, 1993 I–2010 1

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.

ECONOMICS IN PRACTICE
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 Journal
The Economy’s Influence on the Government Budget
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.

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.

REVIEW TERMS AND CONCEPTS
automatic destabilizers privately held federal debt

automatic stabilizers structural deficit
balanced-budget multiplier tax multiplier
budget deficit 1. Disposable income Yd ≡ Y − T
cyclical deficit 2. AE ≡ C + I + G
discretionary fiscal policy 3. Government budget deficit ≡ G − T
disposable, or after-tax, income (Yd) 4. Equilibrium in an economy with a
federal budget government: Y = C + I + G
federal debt 5. Saving/investment approach to
equilibrium in an economy with a
federal surplus (+) or deficit (−)

government: S + T = I + G
fiscal drag 1
6. Government spending multiplier ≡ MPS
fiscal policy
full-employment budget  MPC 

7. Tax multiplier ≡  
government spending multiplier  MPS 
monetary policy
8. Balanced-budget multiplier ≡ 1
net taxes (T)
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  bT  I  G
This equation can be rearranged to yield

Y  bY  a  I  G  bT
Y ( 1  b )  a  I  G  bT
Now solve for Y by dividing through by (1 − b):
1
Y  (a  I  G  bT )
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
1  b  36 of 42
It is easy to show formally that the balanced-budget multiplier = 1.
increase in spending: G
− decrease in spending: C  T ( MPC )
= net increase in spending G  T ( MPC )
In a balanced-budget increase, G = T; so we can substitute:

net initial increase in spending:

G − G (MPC) = G (1 − MPC)

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.

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 )

The Case in Which Tax Revenues Depend on Income
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.

The Case in Which Tax Revenues Depend on Incomes
The Government Spending and Tax Multipliers Algebraically
C  a  b (Y  T )
C  a  b(Y  T0  tY )
C  a  bY  bT0  btY
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
The Case in Which Tax Revenues Depend on Incomes
The Government Spending and Tax Multipliers Algebraically
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

CH 09

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CH 09

Uploaded by

Copyright:

Available Formats

PRINCIPLES OF

CASE FAIR OSTER

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 2 of 42

Fiscal Policy Since 1993: The Clinton, Bush, and Obama

monetary policy The behavior of the Federal Reserve

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 4 of 42

disposable, or after-tax, income (Yd) Total income minus net taxes:

disposable income ≡ total income − net taxes

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 of 42

 FIGURE 9.1 Adding Net Taxes

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 6 of 42

The disposable income (Yd) of households must end up as either

By adding T to both sides:

budget deficit The difference between what a government spends

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 8 of 42

Adding Taxes to the Consumption Function

To modify our aggregate consumption function to

Our consumption function now has consumption depending

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 9 of 42

The government can affect investment behavior through its

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 10 of 42

The Determination of Equilibrium Output (Income)

TABLE 9.1 Finding Equilibrium for I = 100, G = 100, and T = 100

Planned Planned Unplanned

300 100 200 250  50 100 100 450  150 Output ↑

700 100 600 550 50 100 100 750  50 Output ↑

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 11 of 42

The Determination of Equilibrium Output (Income)

 FIGURE 9.2 Finding Equilibrium

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 12 of 42

The Determination of Equilibrium Output (Income)

The Saving/Investment Approach to Equilibrium

saving/investment approach to equilibrium:

To derive this, we know that in equilibrium, aggregate

(AE). By definition, AE equals C + I + G, and by definition,

Subtracting C from both sides leaves:

Government spending multiplier

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 14 of 42

The Government Spending Multiplier

government spending multiplier The ratio of the change in the

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 15 of 42

The Government Spending Multiplier

TABLE 9.2 Finding Equilibrium after a Government Spending Increase of 50 (G Has

500 100 400 400 0 100 150 650 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 ↓

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 16 of 42

The Government Spending Multiplier

 FIGURE 9.3 The Government

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 17 of 42

The Tax Multiplier

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

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

The Balanced-Budget Multiplier

balanced-budget multiplier The ratio of change in the equilibrium

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 19 of 42

The Balanced-Budget Multiplier

Planned Planned Unplanned

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