The Government and Fiscal Policy

1
CHAPTER 20
The Government and

Fiscal Policy
Prepared by: Fernando Quijano

and Yvonn Quijano
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Government in the Economy
• Nothing arouses as much controversy as

the role of government in the economy.
• Government can affect the macroeconomy
through two policy channels: fiscal policy
and monetary policy.
• Fiscal policy is the manipulation of
government spending and taxation.
• Monetary policy refers to the behavior of the
Federal Reserve regarding the nation’s
money supply.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 2
Government in the Economy
• Tax rates are controlled by the

government, but tax revenue depends on
changes in household income and the size
of corporate profits, which the government
cannot control.
• Discretionary fiscal policy refers to
changes in taxes or spending that are the
result of deliberate changes in government
policy.
Net Taxes (T), and Disposable Income (Yd)
• Net taxes are taxes paid by firms and

households to the government minus
transfer payments made to households by
the government.
• Disposable, or after-tax, income (Yd)
equals total income minus taxes.
Yd  Y  T
Adding Net Taxes (T) and Government Purchases
(G) to the Circular Flow of Income
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:
Yd  Y  T
Yd  C  S
Y  T  C S
Y  C S  T
• And aggregate expenditure (AE) equals:
AE  C  I  G
The Budget Deficit
• A government’s budget deficit is the

difference between what it spends (G) and
what it collects in taxes (T) in a given
period:
Budget deficit  G  T
• 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.
Adding Taxes to the
Consumption Function
C  a  bY
C  a  bYd
Yd  Y  T
C  a  b( Y  T )
• With taxes a part of the picture, the

aggregate consumption function is a
function of disposable, or after-tax,
income.
Equilibrium Output: Y = C + I + G
C  100 .75Yd C  100 .75( Y  T )
Finding Equilibrium for I = 100, G = 100, and T = 100
(All Figures in Billions of Dollars)
(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
Y T Yd / Y  T (C = 100 + .75 Yd) (Yd – C) I G C+I+G Y  (C + I + G) DISEQUILIBRIUM
300 100 200 250  50 100 100 450  50 Output8
500 100 400 400 0 100 100 600  100 Output8
700 100 600 550 50 100 100 750  50 Output8
900 100 800 700 100 100 100 900 0 Equilibrium
1,100 100 1,000 850 150 100 100 1,050 + 50 Output9
1,300 100 1,200 1,000 200 100 100 1,200 + 100 Output9
1,500 100 1,400 1,150 250 100 100 1,350 + 150 Output9
Finding Equilibrium
Output/Income Graphically
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,
AE  C  I  G
Y  C S  T
C S  T  C I  G
S T  I G
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.
1
Government spending multiplier 
MPS
Finding Equilibrium After a $50 Billion Government Spending Increase

(All Figures in Billions of Dollars; G Has Increased From 100 in Table 25.1 to 150 Here)
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
OUTPUT NET DISPOSABLE CONSUMPTION SAVING INVESTMENT GOVERNMENT AGGREGATE INVENTORY ADJUSTMENT
(INCOME) TAXES INCOME SPENDING S SPENDING PURCHASES EXPENDITURE CHANGE TO
Y T Yd / Y  T (C = 100 + .75 Yd) (Yd – C) I G C+I+G Y  (C + I + G) DISEQUILIBRIUM
300 100 200 250  50 100 150 500  200 Output8
500 100 400 400 0 100 150 650  150 Output8
700 100 600 550 50 100 150 800  100 Output8
900 100 800 700 100 100 150 950  50 Output8
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 Output9
The Tax Multiplier
• A tax cut increases disposable income,

which is likely to lead to added
consumption spending. Income will
increase by a multiple of the decrease in
taxes.
• However, a tax cut has no direct impact on
spending. The tax multiplier for a change
in taxes is smaller than the multiplier for a
change in government spending.
The Tax Multiplier
 1 
 Y  (initial increase in aggregate expenditure)   
 MPS 
 1   MPC 
 Y  (   T  MPC )      T   
 MPS   MPS 
 MPC 
Tax multiplier    
 MPS 
• However, a tax cut has no direct impact on

spending. The tax multiplier for a change
in taxes is smaller than the multiplier for a
change in government spending.
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.
The Balanced-Budget Multiplier
Finding Equilibrium After a $200 Billion Balanced Budget Increase in G and T

(All Figures in Billions of Dollars; G and T Have Increased From 100 in Table 25.1 to 300 Here)
(1) (2) (3) (4) (5) (6) (7) (8) (9)
OUTPUT NET DISPOSABLE CONSUMPTION INVESTMENT GOVERNMENT AGGREGATE INVENTORY ADJUSTMENT
(INCOME) TAXES INCOME SPENDING SPENDING PURCHASES EXPENDITURE CHANGE TO
Y T Yd / Y  T (C = 100 + .75 Yd) I G C+I+G Y  (C + I + G) DISEQUILIBRIUM
500 300 200 250 100 300 650  150 Output8
700 300 400 400 100 300 800  100 Output8
900 300 600 550 100 300 950  50 Output8
1,100 300 800 700 100 300 1,100 0 Equilibrium
1,300 300 1,000 850 100 300 1,250 + 50 Output9
1,500 300 1,200 1,000 100 300 1,400 + 100 Output9
Fiscal Policy Multipliers
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: MPS MPS
Tax multiplier Increase or decrease in the  MPC  MPC

T 
level of net taxes: MPS MPS
Balanced- Simultaneous balanced-budget

budget increase or decrease in the
1 G
multiplier level of government purchases
and net taxes:
Adding the International Sector
• We can think of imports (IM) as a leakage

from the circular flow and exports (EX) as
an injection into the circular flow.
• With imports and exports, the equilibrium
condition for the economy is:
Open-economy equilibrium: Y  C  I  G  ( X  M )
• The quantity (EX – IM) is referred to as net
exports. Increases or decreases in net
exports can throw the economy out of
equilibrium and cause national income to
change.
The Federal Budget
Federal Government Receipts and Expenditures, 2000 (Billions of Dollars)

PERCENTAGE
AMOUNT OF TOTAL
Receipts
Personal taxes 774.4 44.9
Corporate taxes 211.9 12.3
Indirect business taxes 91.3 5.3
Contributions for social insurance 645.9 37.5
Total 1,723.4 100.0
Current Expenditures
Consumption 463.8 26.5
Transfer payments 795.5 45.4
Grants-in-aid to state and local governments 224.2 12.8
Net interest payments 230.3 13.1
Net subsidies of government enterprises 38.4 2.2
Total 1,752.2 100.0
Current Surplus (+) or deficit () (Receipts  Current Expenditures)  28.8
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
The Federal Government Surplus/Deficit as
a Percentage of GDP, 1970 I2000 IV
The Federal Government Debt as a
Percentage of GDP, 1970 I2000 IV
• The percentage began to fall in the mid 1990s.

The Economy’s 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 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.
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.
Government Budget
• The full-employment budget is a
benchmark for evaluating fiscal
policy.
• The full-employment budget is what
the federal budget would be if the
economy were producing at a full-
employment level of output.
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.
Appendix A:
The government spending and tax multipliers
• The government spending and tax multipliers when

taxes are a function of income are derived as follows:
Y  C I  G Y  a  bY  bT0  btY  I  G
C  a  b(Y  T ) Y  bY  btY  a  bT0  I  G
Yd  Y  T Y (1  b  bt )  a  bT0  I  G
T  T0  tY Y
1
(a  bT0  I  G)
1  b  bt
I  I0 multiplier value of autonomous
expenditures
G  G0
Appendix A: The Balanced-Budget Multiplier
• If we combine the effects of the government

spending multiplier and the tax multiplier, we
obtain:
Multiplier of Y 1  Y  MPC
government = and  Tax
 G MPS T MPS multiplier
spending
1  MPC MPS
then:   1
MPS MPS MPS
• In words, a simultaneous increase in government
spending by $1 and lump-sum taxes by $1 will
increase equilibrium income by $1.
Appendix B:
The government spending and tax multipliers
• The government spending and tax multipliers are

derived algebraically as follows:
Y  C I  G Y  a  b(Y  T )  I  G
C  a  b(Y  T ) Y  a  bY  bT  I  G
Yd  Y  T Y  bY  a  bT  I  G
Y (1 b)  a  bT  I  G
T  T0
1
I  I0 Y  *
(a  bT  I  G)
1 b
G  G0 multiplier value of autonomous
expenditures

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1

The Government and

Prepared by: Fernando Quijano

• Nothing arouses as much controversy as

• Tax rates are controlled by the

• Net taxes are taxes paid by firms and

• When government enters the picture, the

• A government’s budget deficit is the

• With taxes a part of the picture, the

300 100 200 250  50 100 100 450  50 Output8

500 100 400 400 0 100 100 600  100 Output8

700 100 600 550 50 100 100 750  50 Output8

900 100 800 700 100 100 100 900 0 Equilibrium

1,100 100 1,000 850 150 100 100 1,050 + 50 Output9

• Taxes (T) are a leakage from the flow of

• The government spending multiplier is the

Finding Equilibrium After a $50 Billion Government Spending Increase

300 100 200 250  50 100 150 500  200 Output8

500 100 400 400 0 100 150 650  150 Output8

700 100 600 550 50 100 150 800  100 Output8

900 100 800 700 100 100 150 950  50 Output8

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 Output9

• A tax cut increases disposable income,

• However, a tax cut has no direct impact on

• The balanced-budget multiplier is

Finding Equilibrium After a $200 Billion Balanced Budget Increase in G and T

500 300 200 250 100 300 650  150 Output8

700 300 400 400 100 300 800  100 Output8

900 300 600 550 100 300 950  50 Output8

1,100 300 800 700 100 300 1,100 0 Equilibrium

1,300 300 1,000 850 100 300 1,250 + 50 Output9

1,500 300 1,200 1,000 100 300 1,400 + 100 Output9

Summary of Fiscal Policy Multipliers

Tax multiplier Increase or decrease in the  MPC  MPC

Balanced- Simultaneous balanced-budget

• We can think of imports (IM) as a leakage

Federal Government Receipts and Expenditures, 2000 (Billions of Dollars)

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

• The cyclical deficit is the

• The government spending and tax multipliers when

C  a  b(Y  T ) Y  bY  btY  a  bT0  I  G

• If we combine the effects of the government

• The government spending and tax multipliers are

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