Government and Fiscal Policy: An Introduction

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The Government
and Fiscal Policy
OUTLINE
Government in the Economy
Government Purchases (G), Net Taxes (T),
and Disposable income (Y
d
)
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 2007
Fiscal Policy Since 1993: The Clinton and Bush
Administrations
The Federal Government Debt
The Economys Influence on the Government
Budget
Tax 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
The Government and Fiscal
Policy
fiscal policy The governments
spending and taxing policies.
monetary policy The behavior
of the BSP concerning the
nations money supply.
The behavior of the BSP concerning
the nations money supply is called:
a. Discretionary fiscal policy.
b. Automatic fiscal policy.
c. Budgetary policy.
d. Monetary policy.
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The behavior of the Central Bank
concerning the nations money
supply is called:
a. Discretionary fiscal policy.
b. Automatic fiscal policy.
c. Budgetary policy.
d. d. Monetary policy. Monetary policy.
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discretionary fiscal policy Changes in
taxes or spending that are the result of
deliberate changes in government policy.
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 (Y
d
) Total income
minus net taxes: Y - T.
Government Purchases (G), Net Taxes (T), and
Disposable Income (Y
d
)
disposable income total income net taxes
Y
d
Y T
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Over which of the following categories
does the government have more
control?
a. Tax revenue.
b. Government expenditures.
c. Tax rates.
d. The size of corporate profits.
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Over which of the following categories
does the government have more
control?
a. Tax revenue.
b. Government expenditures.
c. c. Tax rates. Tax rates.
d. The size of corporate profits.
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Government Purchases (G), Net Taxes (T),
and Disposable Income (Y
d
)
FIGURE .1 Adding
Net Taxes (T) and
Government
Purchases (G) to the
Circular Flow of
Income
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Select the best answer. Households
use their disposable income (Y
d
) to
do the following:
a. Consume.
b. Consume and save.
c. Consume, save, and pay taxes.
d. Consume, save, pay taxes, and buy
imports.
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Select the best answer. Households
use their disposable income (Y
d
) to
do the following:
a. Consume.
b. b. Consume and save. Consume and save.
c. Consume, save, and pay taxes.
d. Consume, save, pay taxes, and buy
imports.
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Government Purchases (G), Net Taxes (T), and
Disposable Income (Y
d
)
When government enters the picture, the
aggregate income identity gets cut into
three pieces:
Y Y T
d

Y C S
d
+
Y T C S +
Y C S T + +
And aggregate expenditure (AE) equals:
AE C I G = + +
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Government Purchases (G), Net Taxes (T), and Disposable Income
(Y
d
)
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
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Government Purchases (G), Net Taxes (T), and Disposable Income (Y
d
)
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 + bY
d
C = a + b(Y T)
Our consumption function now has consumption depending on
disposable income instead of before-tax income.
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When government enters the circular
flow of income, which of the
following is an expression for
planned aggregate expenditure?
a. Y T
b. C + S + T
c. C + I + G
d. G T
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When government enters the circular
flow of income, which of the
following is an expression for
planned aggregate expenditure?
a. Y T
b. C + S + T
c. C + I + G C + I + G
d. G T
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Government Purchases (G), Net Taxes (T), and Disposable Income (Y
d
)
Planned Investment
The government can affect
investment behavior through its
tax treatment of depreciation and
other tax policies.
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AGGREGATE OUTPUT AND
AGGREGATE INCOME (Y)
aggregate output The total quantity of goods and
services produced in an economy in a given period.
aggregate income The total income received by all
factors of production in a given period.
aggregate output (income) (Y) A combined term
used to remind you of the exact equality between
aggregate output and aggregate income.
In any given period, there is an exact equality between
aggregate output (production) & aggregate income. You
should be reminded of this fact whenever you encounter the
combined term aggregate output (income) (Y).
Important to Note:
This session presents the basic Keynesian
macroeconomic model
The Keynesian model assumes that producers
meet demand at preset prices.
All of the adjustment is quantity
The shortcoming of their assumption is that it
does not explain changes in prices and inflation.
Think in Real Terms
When we talk about output (Y), we mean
real output (real GDP), not nominal output
(P x Y).
The main point is to think of Y as being in
real termsthe quantities of goods &
services produced, not the dollars/pesos
circulating in the economy.
Another Important Note:
Saving Aggregate Income Consumption
INCOME, CONSUMPTION, AND SAVING
(Y, C, AND S)
saving (S) The part of its income that a
household does not consume in a given period.
Distinguished from savings,
which is the current stock of accumulated saving.
Saving income consumption
S Y C
identity Something that is always true.
NOTE on Stocks & Flows
We distinguish between economics
concepts that are stocks or flows
Flow concepts are per unit of time
Stock concepts have no time element
Income (Y), consumption (C) and saving
(S) are flow concepts Why?
Savings, wealth, money in your bank
account, the level of employment are stock
concepts Why?
What is the government deficit?
What is the level of the national debt?
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Household Consumption and Saving
Things that determine aggregate consumption include:
1. Household income (direct, positive)
2. Household wealth (direct, positive)
3. Interest rates (negative)
4. Households expectations about the future
(expectations about what?)
The higher your income is, the higher your
consumption is likely to be. People with more income
tend to consume more than people with less income.
consumption function The relationship bet. consumption &
income.
The Keynesian Theory of Consumption
consumption function The relationship between
consumption and income.
A Consumption
Function for a
Household
A consumption
function for an
individual
household shows
the level of
consumption at
each level of
household
income.
With a straight line consumption curve, we can use
the following equation to describe the curve:
C = a + bY
An Aggregate
Consumption Function
The aggregate
consumption function
shows the level of
aggregate consumption at
each level of aggregate
income.
The upward slope
indicates that higher
levels of income lead to
higher levels of
consumption spending.
Because the aggregate consumption function is a straight
line, we can write the following equation to describe it:
C = a + bY
marginal propensity to consume (MPC) That fraction of a change
in income that is consumed, or spent. The slope (b) of the
consumption function is the MPC.
Y
C
function n consumptio of slope (MPC) consume to propensity marginal

0 1 < b<
The Aggregate Consumption Function
Because the MPC and the MPS are important
concepts, it may help to review their definitions.
That fraction of a change in income that
is saved. Remember:
MPC + MPS 1
The marginal propensity to consume (MPC) is the fraction of an increase in income
that is consumed (or the fraction of a decrease in income that comes out of
consumption). The marginal propensity to save (MPS) is the fraction of an increase in
income that is saved (or the fraction of a decrease in income that comes out of saving).
marginal propensity to save (MPS)
Y
S
(MPS) save to propensity marginal

S Y C
An Aggregate Consumption Function Derived from the Equation
C = 100 + .75Y
Numerical Example
AGGREGATE
INCOME, Y
(BILLIONS OF
DOLLARS)
AGGREGATE
CONSUMPTION, C
(BILLIONS OF
DOLLARS)
0 100
80 60
100 175
200 250
400 400
600 550
800 700
1,000 850
The Aggregate Consumption Function
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The Aggregate Consumption Function Derived from the
Equation C = 100 + .75Y
Note:
At aggregate income
of zero, consumption
is $100 billion.
For every $100
billion increase in
income (Y),
consumption rises
by $75 billion (C).
Exercise
AGGREGATE
INCOME, Y
(BILLIONS OF DOLLARS)
AGGREGATE
CONSUMPTION, C
0
100
200
400
600
800
1,000
C = 100 +.90Y
Answer
C = 100 +.90Y
AGGREGATE
INCOME, Y
AGGREGATE CONSUMPTION,
C
0 100
100 190
200 280
400 460
600 640
800 820
1,000 1000
45-degree guide line
45
o
Aggregate Income (Y)
A
g
g
r
e
g
a
t
e
C
o
n
s
u
m
p
t
i
o
n
(
C
)
1000
1
0
0
0
Y - C = S
AGGREGATE
INCOME
(Billions of
Dollars)
AGGREGATE
CONSUMPTION
(Billions of
Dollars)
AGGREGATE
SAVING
(Billions of
Dollars)
0 100 -100
80 160 -80
100 175 -75
200 250 -50
400 400 0
600 550 50
800 700 100
1,000 850 150
Deriving a Saving Function from a Consumption Function
Exercise
C = 100 + .75 Y
S = Y - C
S = ?
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Where the consumption function is above
the 45line, consumption exceeds income,
and saving is negative.
Where the consumption function crosses
the 45line, consumption is equal to
income, and saving is zero.
Where the consumption function is below
the 45line, consumption is less than
income, and saving is positive.
PLANNED INVESTMENT (I)
What Is Investment?
investment Purchases by firms of
new buildings & equipment &
additions to inventories, all of which
add to firms capital stock.
Actual versus Planned Investment
Not everything produced gets sold
change in inventory: Production minus sales.
One component of investmentinventory change
is partly determined by how much households
decide to buy, which is not under the complete
control of firms. If households do not buy as much
as firms expect them to, inventories will be higher
than expected, & firms will have made an inventory
investment that they did not plan to make.
desired, or planned, investment (I)
Those additions to capital stock and
inventory that are planned by firms.
actual investment The actual amount
of investment that takes place; it
includes items such as unplanned
changes in inventories.
Actual versus Planned Investment
The Planned Investment Function
For now, we will
assume that planned
investment is fixed. It
does not change
when income
changes.
When a variable,
such as planned
investment, is
assumed not to
depend on the state
of the economy, it is
said to be an
autonomous
variable.
The Determination of Equilibrium Output (Income)
equilibrium Occurs when there is no tendency for
change. In the macroeconomic goods market,
equilibrium occurs when planned aggregate
expenditure is equal to aggregate output.
planned aggregate expenditure (AE) The total
amount the economy plans to spend in a given
period. Equal to consumption plus planned
investment: AE C + I.
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aggregate output Y (amount produced)
planned aggregate expenditure AE C + I
( amount purchased)
equilibrium: Y = AE, or Y = C + I
Y > C + I
Aggregate output > planned aggregate expenditure
More is produced than sold. The excess goes into unplanned
inventory.
Inventory investment is greater than planned.
Actual investment is greater than planned investment
C + I > Y
Planned aggregate expenditure > aggregate output
More is sold than produced. The is met by reducing inventory.
Inventory investment is smaller than planned.
Actual investment is less than planned investment
Equilibrium in the goods market is achieved only when aggregate
output (Y) and planned aggregate expenditure (C + I) are equal, or
when actual and planned investment are equal.
TABLE 8.1 Deriving the Planned Aggregate Expenditure Schedule and Finding
Equilibrium (All Figures in Billions of Dollars) The Figures in Column 2 Are
Based on the Equation C = 100 + .75Y.
(1) (2) (3) (4) (5) (6)
AGGREGATE
OUTPUT
(INCOME) (Y)
AGGREGATE
CONSUMPTION (C)
PLANNED
INVESTMENT (I)
PLANNED
AGGREGATE
EXPENDITURE(AE)
C + I
UNPLANNED
INVENTORY
CHANGE
Y (C + I)
EQUILIBRIUM?
(Y = AE?)
100 175 25 200 100 No
200 250 25 275 75 No
400 400 25 425 25 No
500 475 25 500 0 Yes
600 550 25 575 + 25 No
800 700 25 725 + 75 No
1,000 850 25 875 + 125 No
Equilibrium occurs
when planned
aggregate expenditure
& aggregate output are
equal.
Planned aggregate
expenditure is the sum
of consumption
spending & planned
investment spending.
Test Yourself
Suppose the Figures in Column 2 Below are Based on the Equation C = 100 + .80Y.
(1) (2) (3) (4) (5) (6)
AGGREGATE
OUTPUT
(INCOME) (Y)
AGGREGATE
CONSUMPTION (C)
PLANNED
INVESTMENT (I)
PLANNED
AGGREGATE
EXPENDITURE(AE)
C + I
UNPLANNED
INVENTORY
CHANGE
Y (C + I)
EQUILIBRIUM?
(Y = AE?)
125 25
225 25
425 25
525 25
625 25
825 25
925 25
Test Yourself
Suppose the Figures in Column 2 are Based on the Equation C = 100 + .80Y.
(1) (2) (3) (4) (5) (6)
AGGREGATE
OUTPUT
(INCOME) (Y)
AGGREGATE
CONSUMPTION (C)
PLANNED
INVESTMENT (I)
PLANNED
AGGREGATE
EXPENDITURE(AE)
C + I
UNPLANNED
INVENTORY
CHANGE
Y (C + I)
EQUILIBRIUM?
(Y = AE?)
125 200 25 225 100 No
225 280 25 305 -80 No
425 440 25 465 40 No
525 520 25 545 -20 No
625 600 25 625 0 Yes
825 760 25 785 + 40 No
925 840 25 865 + 60 No
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Y Y = + + 100 75 25 .
Y C I = +
(1)
C Y = + 100 75 . (2)
I = 25
(3)
By substituting (2) and
(3) into (1) we get:
There is only one value of Y
for which this statement is
true. We can find it by
rearranging terms:
Y Y = + .75 100 25
Y Y = .75 125
.25 125 Y =
Y = =
125
25
500
.
Y Y = + + 100 75 25 .
S Y - C, which is an identity.
The equilibrium condition is Y = C + I. But this is not
an identity because it does not hold when we are out
of equilibrium.
From Y = C + I, we get
Y - C = I
We know S Y C. We can substitute and get:
S = I
Thus, only when planned investment equals saving
will there be equilibrium.
The Saving/Investment Approach to Equilibrium
The Saving/Investment Approach to Equilibrium
THE MULTIPLIER
multiplier The ratio of the change in the
equilibrium level of output to a change in
some exogenous variable.
exogenous variable A variable that is
assumed not to depend on the state of the
economythat is, it does not change when
the economy changes.
In this chapter, for example, we consider
planned investment to be autonomous
The Multiplier:
MPC =.75 and I increases by 100
Change in I Change in Y Change in C
100 100 75
75 56.25
56.25 42.18
42.18 31.64
31.64 23.73
400 300
Round 1
Round 2
Round 3
Round 4
Round n
The Multiplier
Holding A LOT of other things constant, the
size of the multiplier depends on the size of
the MPC.
The formula for the spending multiplier = The formula for the spending multiplier =
1 / ( 1 1 / ( 1-- MPC) = 1 / (MPS) MPC) = 1 / (MPS)
1 / (1 1 / (1 -- 0.75) = 1 / 0.25 = 4 0.75) = 1 / 0.25 = 4
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Multiplier Exercise: MPC =.80
100 100
Round 2
Round 1
Round 3
Round 4
Round N
Multiplier Exercise: MPC =.80
100 100 80
80 64
64 51.20
51.20 40.96
40.96 32.76
500 400
Round 1
Round 2
Round 3
Round 4
Round N
The spending multiplier = 1 / ( 1 The spending multiplier = 1 / ( 1-- MPC) = 1 / (MPS) MPC) = 1 / (MPS)
1 / (1 1 / (1 -- 0.80) = 1 / 0.20 = 5 0.80) = 1 / 0.20 = 5
THE MULTIPLIER
FIGURE 8.11 The Multiplier as Seen in the Planned Aggregate Expenditure Diagram
The Multiplier
The Multiplier as Seen in the
Planned Aggregate
Expenditure Diagram
At point A, the economy is
in equilibrium at Y = 500.
When I increases by 25,
planned aggregate
expenditure is initially
greater than aggregate
output. As output rises in
response, additional
consumption is generated,
pushing equilibrium output
up by a multiple of the
initial increase in I.
The new equilibrium is
found at point B, where Y
= 600. Equilibrium output
has increased by 100 (600
- 500), or four times the
amount of the increase in
planned investment.
The Multiplier
The Size of the Multiplier in the Real World
In considering the size of the multiplier, it is
important to realize that the multiplier we derived
in this chapter is based on a very simplified
picture of the economy.
In reality the size of the multiplier is about 1.4.
That is, a sustained increase in exogenous
spending of $10 billion into the U.S. economy can
be expected to raise real GDP over time by about
$14 billion.
The Paradox of Thrift
When households become
concerned about the
future and decide to save
more, the corresponding
decrease in consumption
leads to a drop in
spending and income.
Households end up consuming less, but
they have not saved any more.
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Problem 1. Government of Ababa
Consumption function: C = 150 + 0.8 (Y - T)
Government expenditures: G = 300
Tax revenues: T = 250
Investment = 100
a. What is the budget surplus or deficit of Ababa?
b. What are the values of the government spending
multiplier and the tax multiplier?
c. What are the equilibrium values of GDP, consumption,
and savings?
d. What will they be if taxes are increased by 50?
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Fiscal Policy and Aggregate Demand
Fiscal policy: the setting of the level of govt
spending and taxation by govt
policymakers
Expansionary fiscal policy
an increase in G and/or decrease in T
shifts AD right
Contractionary fiscal policy
a decrease in G and/or increase in T
shifts AD left
Fiscal policy has two effects on AD...
1. The Multiplier Effect
If the govt buys $20b of planes from Boeing,
Boeings revenue increases by $20b.
This is distributed to Boeings workers (as wages)
and owners (as profits or stock dividends).
These people are also consumers and will spend a
portion of the extra income.
This extra consumption causes further increases in
aggregate demand.
Multiplier effect: the additional shifts in AD
that result when fiscal policy increases income
and thereby increases consumer spending
1. The Multiplier Effect
A $20b increase in G
initially shifts AD
to the right by $20b.
The increase in Y
causes C to rise,
which shifts AD
further to the right.
Y
P
AD
1
P
1
AD
2
AD
3
Y
1
Y
3
Y
2
$20
billion
Marginal Propensity to Consume
How big is the multiplier effect?
It depends on how much consumers
respond to increases in income.
Marginal propensity to consume (MPC):
the fraction of extra income that
households consume rather than save
E.g., if MPC = 0.8 and income rises $100,
C rises $80.
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Notation: G is the change in G,
Y and C are the ultimate changes in Y and C
Y = C + I + G + NX identity
Y = C + G I and NX do not change
Y = MPC Y + G because C = MPC Y
solved for Y
1
1 MPC
Y = G
A Formula for the Multiplier
The multiplier
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The size of the multiplier depends on MPC.
E.g., if MPC = 0.5 multiplier = 2
if MPC = 0.75 multiplier = 4
if MPC = 0.9 multiplier = 10
1
1 MPC
Y = G
A Formula for the Multiplier
The multiplier
A bigger MPC means
changes in Y cause
bigger changes in C,
which in turn cause
more changes in Y.
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Other Applications of the Multiplier Effect
The multiplier effect:
Each $1 increase in G can generate
more than a $1 increase in agg demand.
Also true for the other components of GDP.
Example: Suppose a recession
overseas reduces demand for U.S.
net exports by $10b.
Initially, agg demand falls by $10b.
The fall in Y causes C to fall, which
further reduces agg demand and
income.
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2. The Crowding-Out Effect
Fiscal policy has another effect on AD
that works in the opposite direction.
A fiscal expansion raises r,
which reduces investment,
which reduces the net increase in agg
demand.
So, the size of the AD shift may be smaller
than the initial fiscal expansion.
This is called the crowding-out effect.
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How the Crowding-Out Effect Works
Y
P
M
Interest
rate
AD
1
MS
MD
2
MD
1
P
1
r
1
r
2
A $20b increase in G initially shifts AD right by
$20b
But higher Y increases MD and r, which reduces AD.
AD
3
AD
2
Y
1
Y
2
$20
billion
Y
3
Changes in Taxes
A tax cut increases households take-home pay.
Households respond by spending a portion of this
extra income, shifting AD to the right.
The size of the shift is affected by the multiplier &
crowding-out effects.
Another factor: whether households perceive the
tax cut to be temporary or permanent.
A permanent tax cut causes a bigger increase in C
and a bigger shift in the AD curve
than a temporary tax cut.
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A C T ! v E L E A R N ! N G A C T ! v E L E A R N ! N G
Exercise Exercise
The economy is in recession.

Shifting the AD curve rightward by $200b
would end the recession.
A. If MPC = .8 and there is no crowding out,
how much should Congress increase G
to end the recession?
B. If there is crowding out, will Congress need
to increase G more or less than this
amount?
Answers Answers

A. If MPC = .8 and there is no crowding out,
how much should Congress increase G
to end the recession?
Multiplier = 1/(1 .8) = 5
Increase G by $40b
to shift agg demand by 5 x $40b = $200b.
Answers Answers

B. If there is crowding out, will Congress need
to increase G more or less than this
amount?
Crowding out reduces the impact of G on
AD.
To offset this, Congress should increase G
by a larger amount.
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Fiscal Policy & Aggregate Supply
Most economists believe the short-run effects of fiscal
policy mainly work through agg demand.
But fiscal policy might also affect agg supply.
Recall one of the Ten Principles from Session 1:
People respond to incentives.
A cut in the tax rate gives workers incentive to work more,
so it might increase the quantity of g&s supplied and
shift AS to the right.
People who believe this effect is large are called Supply-
siders.
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Fiscal Policy and Aggregate Supply
Govt purchases might affect agg supply. Example:
Govt increases spending on roads.
Better roads may increase business productivity, which
increases the quantity of g&s supplied, shifts AS to
the right.
This effect is probably more relevant in the long run: it
takes time to build the new roads and put them into use.
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Using Policy to Stabilize the Economy
Since the Employment Act of 1946, economic
stabilization has been a goal of U.S.
policy.
Economists debate how active a role the govt
should take to stabilize the economy.
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The Case for Active Stabilization Policy
Keynes: Animal spirits cause waves of
pessimism and optimism among
households and firms, leading to shifts in
aggregate demand and fluctuations in
output and employment.
Also, other factors cause fluctuations, e.g.,
booms and recessions abroad
stock market booms and crashes
If policymakers do nothing, these fluctuations
are destabilizing to businesses, workers,
consumers.
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The Case for Active Stabilization Policy
Proponents of active stabilization policy
believe the govt should use policy
to reduce these fluctuations:
When GDP falls below its natural rate,
use expansionary monetary or fiscal
policy
to prevent or reduce a recession.
When GDP rises above its natural rate,
use contractionary policy to prevent or
reduce an inflationary boom.
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Keynesians in the White House
1961:
John F Kennedy pushed for a
tax cut to stimulate agg
demand. Several of his
economic advisors were
followers of Keynes.
2001:
George W Bush pushed for a
tax cut that helped the
economy recover from a
recession that
had just begun.
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The Case Against Active Stabilization Policy
Monetary policy affects economy with a long lag:
Firms make investment plans in advance,
so I takes time to respond to changes in r.
Most economists believe it takes at least
6 months for mon policy to affect output
and employment.
Fiscal policy also works with a long lag:
Changes in G and T require Acts of
Congress.
The legislative process can take months or
years.
THE
INFLUE
NCE OF
MONET
ARY
83
The Case Against Active Stabilization Policy
Due to these long lags, critics of active policy
argue that such policies may destabilize the
economy rather than help it:
By the time the policies affect agg demand,
the economys condition may have changed.
These critics contend that policymakers should
focus on long-run goals like economic
growth and low inflation.
THE
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84
Automatic Stabilizers
Automatic stabilizers:
changes in fiscal policy that stimulate
agg demand when economy goes into
recession, without policymakers having to take
any deliberate action
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15
THE
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MONET
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85
Automatic Stabilizers: Examples
The tax system
In recession, taxes fall automatically,
which stimulates agg demand.
Govt spending
In recession, more people apply for public
assistance (welfare, unemployment
insurance).
Govt spending on these programs
automatically rises, which stimulates agg
demand.
THE
INFLUE
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86
CONCLUSION
Policymakers need to consider all the effects of their
actions. For example,
When Congress cuts taxes, it should consider the
short-run effects on agg demand & employment,
&d the long-run effects on saving & growth.
When the FED/BSP reduces the rate of money growth,
it must take into account not only the long-run effects
on inflation but the short-run effects on output &
employment.
Recap of Key Points Recap of Key Points
Expansionary fiscal policy a spending increase or tax
cut shifts aggregate demand to the right.
Contractionary fiscal policy shifts aggregate demand to
the left.
When the government alters spending or taxes, the
resulting shift in aggregate demand can be larger or
smaller than the fiscal change:
- the multiplier effect tends to amplify the effects of
fiscal policy on aggregate demand
- the crowding-out effect tends to dampen the effects
of fiscal policy on aggregate demand
Recap of Key Points Recap of Key Points

Economists disagree about how actively
policymakers should try to stabilize the economy.
Some argue that the government should use
fiscal & monetary policy to combat destabilizing
fluctuations in output and employment.
Others argue that policy will end up destabilizing the
economy because policies work with long lags.
actual investment
aggregate income
aggregate output
aggregate output
(income) (Y)
autonomous variable
change in inventory
consumption function
desired, or planned,
investment
equilibrium
identity
investment
REVIEW TERMS AND CONCEPTS
marginal propensity to consume (MPC)
marginal propensity to save (MPS)
multiplier
paradox of thrift
planned aggregate expenditure (AE)
saving (S)
1. S Y C
2.
3. MPC + MPS 1
4. AE C + I
5. Equilibrium condition: Y = AE or Y = C + I
6. Saving/investment approach to
equilibrium: S = I
7.
function n consumptio of slope
Y
C
MPC
= =
- MPC MPS 1
1

1
Multiplier
DERIVING THE MULTIPLIER ALGEBRAICALLY
Appendix
Recall that our consumption function is:
C = a + bY
where b is the marginal propensity to consume. In equilibrium:
Y = C + I
Now we solve these two equations for Y in terms of I. By
substituting the first equation into the second, we get:
I bY a Y
C
+ + =

3/16/2011
16
Appendix
This equation can be rearranged to yield:
Y bY = a + I
Y(1 b) = a + I
We can then solve for Y in terms of I by dividing through by
(1 b):
+ =
b
I a Y
1
1
) (
Appendix
Now look carefully at this expression and think about
increasing I by some amount, I, with a held constant.
If I increases by I, income will increase by
Because b MPC, the expression becomes
b
I Y
=
1
1
MPC
I Y
=
1
1
Appendix
The multiplier is
Finally, because MPS + MPC 1, MPS is equal to 1 MPC,
making the alternative expression for the multiplier 1/MPS,
just as we saw in this chapter.
MPC 1
1
94 of 63
DERIVING THE FISCAL POLICY MULTIPLIERS
A P P E N D I X
THE GOVERNMENT SPENDING AND TAX MULTIPLIERS
Y C I G = + +
C a b Y T = + ( )
Y a b Y T I G = + + + ( )
Y a bY bT I G = + + +
Y bY a I G bT = + +
Y b a I G bT ( ) 1 = + +
( )
) (
1
1
bT G I a
b
Y + +
=
95 of 63
THE BALANCED-BUDGET MULTIPLIER
The balanced-budget multiplier is
found by combining the effects of
government spending and taxes:
G increase in spending:
( ) C T MPC = - decrease in spending:
( ) G T MPC = net increase in spending
In a balanced-budget increase, G = T;
so we can substitute:
net initial increase in spending:
G G (MPC) = G (1 MPC)
A P P E N D I X
96 of 63
THE BALANCED-BUDGET MULTIPLIER
A P P E N D I X
1
( ) Y G MPS G
MPS

= =

Because MPS = (1 MPC), the net
initial increase in spending is:
G (MPS)
We can now apply the expenditure multiplier
to this net initial increase in spending:
MPS
1
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17
97 of 63
THE CASE IN WHICH TAX REVENUES DEPEND ON INCOME
A P P E N D I X
T Y Y
d

) 3 / 1 200 ( Y Y Y
d
+
Y Y Y
d
3 / 1 200 +
d
Y C 75 . 100+ =
) 3 / 1 200 ( 75 . 100 Y Y C + + =
FIGURE 24B.1 The
Tax Function
98 of 63
A P P E N D I X
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.
FIGURE 24B.2
Different Tax Systems
G I C Y + + =

100 .75( 200 1/ 3 ) 100 100 Y Y Y
I G
C
= + + + +
450 5 .
5 . 450
100 100 25 . 150 75 . 100
=
+ =
+ + + + =
Y
Y Y
Y Y Y
99 of 63
A P P E N D I X
THE GOVERNMENT SPENDING AND TAX MULTIPLIERS ALGEBRAICALLY
C a b Y T = + ( )
0
C a bY bT btY = +
0
( ) C a b Y T tY = +
0
Y a bY bT btY I G
C
= + + +
Y
b bt
a I G bT =
+
+ +
1
1
0
( )
1
1 b bt +

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Government and Fiscal Policy: An Introduction

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3/16/2011

function n consumptio of slope (MPC) consume to propensity marginal

(MPS) save to propensity marginal

The economy is in recession.

The economy is in recession.

The economy is in recession.

Recap of Key Points Recap of Key Points

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