© 2002 prentice hall business publishingprinciples of economics, 6/ekarl case, ray fair government...

© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair

Government in the EconomyGovernment in the Economy

• Nothing arouses as much controversy as Nothing arouses as much controversy as the role of government in the economy.the role of government in the economy.

• Government can affect the macroeconomy Government can affect the macroeconomy through two policy channels: fiscal policy through two policy channels: fiscal policy and monetary policy.and monetary policy.

• Fiscal policyFiscal policy is the manipulation of is the manipulation of government spending and taxation.government spending and taxation.

• Monetary policyMonetary policy refers to the behavior of the refers to the behavior of the Federal Reserve regarding the nation’s money Federal Reserve regarding the nation’s money supply.supply.


Government in the EconomyGovernment in the Economy

• Tax rates are controlled by the Tax rates are controlled by the government, but tax revenue depends on government, but tax revenue depends on changes in household income and the size changes in household income and the size of corporate profits, which the government of corporate profits, which the government cannot control.cannot control.

• Discretionary fiscal policyDiscretionary fiscal policy refers to refers to changes in taxes or spending that are the changes in taxes or spending that are the result of deliberate changes in government result of deliberate changes in government policy.policy.


Net Taxes (Net Taxes (TT), and Disposable Income (), and Disposable Income (YYdd))

• Net taxesNet taxes are taxes paid by firms and are taxes paid by firms and households to the government minus households to the government minus transfer payments made to households by transfer payments made to households by the government.the government.

• DisposableDisposable, or , or after-taxafter-tax, , income (Yincome (Ydd))

equals total income minus taxes.equals total income minus taxes.

Y Y Td


Adding Net Taxes (Adding Net Taxes (TT) and Government Purchases ) and Government Purchases ((GG) to the Circular Flow of Income) to the Circular Flow of Income


Adding Net Taxes (Adding Net Taxes (TT) and Government Purchases ) and Government Purchases ((GG) to the Circular Flow of Income) to the Circular Flow of Income

• When government enters the picture, the When government enters the picture, the aggregate income identity gets cut into aggregate income identity gets cut into three pieces:three pieces:

Y Y Td

Y C Sd

Y T C S Y C S T

• And aggregate expenditure (And aggregate expenditure (AEAE) equals:) equals:

A E C I G


The Budget DeficitThe Budget Deficit

• A government’s A government’s budget deficitbudget deficit is the is the difference between what it spends (difference between what it spends (GG) and ) and what it collects in taxes (what it collects in taxes (TT) in a given ) in a given period:period:

B udget def G Ticit

• If If GG exceeds exceeds TT, the government must , the government must borrow from the public to finance the deficit. borrow from the public to finance the deficit. It does so by selling Treasury bonds and It does so by selling Treasury bonds and bills. In this case, a part of household bills. In this case, a part of household saving (saving (SS) goes to the government.) goes to the government.


Adding Taxes to theAdding Taxes to theConsumption FunctionConsumption Function

• With taxes a part of the picture, the With taxes a part of the picture, the aggregate consumption function is a aggregate consumption function is a function of disposable, or after-tax, function of disposable, or after-tax, income.income.

C a bY C a bYd

Y Y Td

C a b Y T ( )


Equilibrium Output: Equilibrium Output: YY = = CC + + II + + GG

Finding Equilibrium for Finding Equilibrium for I I = 100, = 100, GG = 100, and = 100, and T T = 100= 100(All Figures in Billions of Dollars)(All Figures in Billions of Dollars)

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

OUTPUTOUTPUT(INCOME)(INCOME)

YY

NETNETTAXESTAXES

TT

DISPOSABLEDISPOSABLEINCOMEINCOME

YYdd Y Y TT

CONSUMPTIONCONSUMPTIONSPENDINGSPENDING

((CC = 100 + .75 = 100 + .75 YYdd))

SAVINGSAVINGSS

((YYdd – – CC))

PLANNEDPLANNEDINVESTMENTINVESTMENT

SPENDINGSPENDINGII

GOVERNMENTGOVERNMENTPURCHASESPURCHASES

GG

PLANNEDPLANNEDAGGREGATEAGGREGATE

EXPENDITUREEXPENDITURE CC + + I I + + GG

UNPLANNEDUNPLANNEDINVENTORYINVENTORY

CHANGECHANGEYY ( (CC + + I I + + GG))

ADJUSTMENTADJUSTMENTTOTO

DISEQUILIBRIUMDISEQUILIBRIUM

300300 100100 200200 250250 5050 100100 100100 450450 5050 OutputOutput

500500 100100 400400 400400 00 100100 100100 600600 100100 OutputOutput

700700 100100 600600 550550 5050 100100 100100 750750 5050 OutputOutput

900900 100100 800800 700700 100100 100100 100100 900900 00 EquilibriumEquilibrium

1,1001,100 100100 1,0001,000 850850 150150 100100 100100 1,0501,050 + 50+ 50 OutputOutput

1,3001,300 100100 1,2001,200 1,0001,000 200200 100100 100100 1,2001,200 + 100+ 100 OutputOutput

1,5001,500 100100 1,4001,400 1,1501,150 250250 100100 100100 1,3501,350 + 150+ 150 OutputOutput

C Yd 1 0 0 7 5. C Y T 1 0 0 7 5. ( )


Finding EquilibriumFinding EquilibriumOutput/Income GraphicallyOutput/Income Graphically


The Leakages/Injections ApproachThe Leakages/Injections Approach

• Taxes (Taxes (TT) are a leakage from the flow of ) are a leakage from the flow of income. Saving (income. Saving (SS) is also a leakage.) is also a leakage.

• In equilibrium, aggregate output (income) In equilibrium, aggregate output (income) ((YY) equals planned aggregate expenditure ) equals planned aggregate expenditure ((AEAE), and leakages (), and leakages (SS + + TT) must equal ) must equal planned injections (planned injections (II + + GG). Algebraically,). Algebraically,

S T I G

A E C I G Y C S T

C S T C I G


The Government Spending MultiplierThe Government Spending Multiplier

• The government spending multiplier is the The government spending multiplier is the ratio of the change in the equilibrium level ratio of the change in the equilibrium level of output to a change in government of output to a change in government spending.spending.

G overnm en t m ultip lierM P S

spend ing 1



Finding Equilibrium After a $50 Billion Government Spending IncreaseFinding Equilibrium After a $50 Billion Government Spending Increase(All Figures in Billions of Dollars; (All Figures in Billions of Dollars; GG Has Increased From 100 in Table 25.1 to 150 Here) Has Increased From 100 in Table 25.1 to 150 Here)

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


YY

NETNETTAXESTAXES

TT

DISPOSABLEDISPOSABLEINCOMEINCOME

YYdd Y Y TT


((CC = 100 + .75 = 100 + .75 YYdd))

SAVINGSAVINGSS

((YYdd – – CC))


SPENDINGSPENDINGII


GG







300300 100100 200200 250250 5050 100100 150150 500500 200200 OutputOutput

500500 100100 400400 400400 00 100100 150150 650650 150150 OutputOutput

700700 100100 600600 550550 5050 100100 150150 800800 100100 OutputOutput

900900 100100 800800 700700 100100 100100 150150 950950 5050 OutputOutput

1,1001,100 100100 1,0001,000 850850 150150 100100 150150 1,1001,100 00 EquilibriumEquilibrium

1,3001,300 100100 1,2001,200 1,0001,000 200200 100100 150150 1,2501,250 + 50+ 50 OutputOutput


The Tax MultiplierThe Tax Multiplier

• A tax cut increases disposable income, A tax cut increases disposable income, which is likely to lead to added which is likely to lead to added consumption spending. Income will consumption spending. Income will increase by a multiple of the decrease in increase by a multiple of the decrease in taxes.taxes.

• However, a tax cut has no direct impact on However, a tax cut has no direct impact on spending. The tax multiplier for a change spending. The tax multiplier for a change in taxes is smaller than the multiplier for a in taxes is smaller than the multiplier for a change in government spending.change in government spending.


The Tax MultiplierThe Tax Multiplier

• However, a tax cut has no direct impact on However, a tax cut has no direct impact on spending. The tax multiplier for a change spending. The tax multiplier for a change in taxes is smaller than the multiplier for a in taxes is smaller than the multiplier for a change in government spending.change in government spending.

YM P S

( in itia l in c rease in ag g reg a te ex p en d itu re )

1

Y T M P CM P S

TM P C

M P S

( )

1

T ax m ultipM P C

M P Slier


The Balanced-Budget MultiplierThe Balanced-Budget Multiplier

• The The balanced-budget multiplierbalanced-budget multiplier is is the ratio of change in the equilibrium the ratio of change in the equilibrium level of output to a change in level of output to a change in government spending where the government spending where the change in government spending is change in government spending is balanced by a change in taxes so as balanced by a change in taxes so as not to create any deficit.not to create any deficit.


The Balanced-Budget MultiplierThe Balanced-Budget Multiplier

Finding Equilibrium After a $200 Billion Balanced Budget Increase in Finding Equilibrium After a $200 Billion Balanced Budget Increase in GG and and TT(All Figures in Billions of Dollars; (All Figures in Billions of Dollars; GG and and TT Have Increased From 100 in Table 25.1 to 300 Here) Have Increased From 100 in Table 25.1 to 300 Here)

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


YY

NETNETTAXESTAXES

TT

DISPOSABLEDISPOSABLEINCOMEINCOMEYYdd Y Y TT


((CC = 100 + .75 = 100 + .75 YYdd))


SPENDINGSPENDINGII


GG







500500 300300 200200 250250 100100 300300 650650 150150 OutputOutput

700700 300300 400400 400400 100100 300300 800800 100100 OutputOutput

900900 300300 600600 550550 100100 300300 950950 5050 OutputOutput

1,1001,100 300300 800800 700700 100100 300300 1,1001,100 00 EquilibriumEquilibrium

1,3001,300 300300 1,0001,000 850850 100100 300300 1,2501,250 + 50+ 50 OutputOutput

1,5001,500 300300 1,2001,200 1,0001,000 100100 300300 1,4001,400 + 100+ 100 OutputOutput


Fiscal Policy MultipliersFiscal Policy Multipliers

Summary of Fiscal Policy MultipliersSummary of Fiscal Policy Multipliers

POLICY STIMULUSPOLICY STIMULUS MULTIPLIERMULTIPLIERFINAL IMPACT ONFINAL IMPACT ON

EQUILIBRIUM EQUILIBRIUM YY

Government-Government-spendingspendingmultipliermultiplier

Increase or decrease in theIncrease or decrease in thelevel of governmentlevel of governmentpurchases:purchases:

Tax multiplierTax multiplier Increase or decrease in theIncrease or decrease in thelevel of net taxes: level of net taxes:

Balanced-Balanced-budgetbudgetmultipliermultiplier

Simultaneous balanced-budgetSimultaneous balanced-budgetincrease or decrease in theincrease or decrease in thelevel of government purchaseslevel of government purchasesand net taxes: and net taxes:

11

1

M P S

M P C

M P S

GM P S

1

TM P C

M P S

G


Adding the International SectorAdding the International Sector

• We can think of imports (We can think of imports (IMIM) as a leakage ) as a leakage from the circular flow and exports (from the circular flow and exports (EXEX) as ) as an injection into the circular flow.an injection into the circular flow.

• With imports and exports, the equilibrium With imports and exports, the equilibrium condition for the economy is:condition for the economy is:

O pen-econo m y equ ilib rium : Y C I G X M ( )

• The quantity (The quantity (EXEX – – IMIM) is referred to as ) is referred to as net net exports.exports. Increases or decreases in net Increases or decreases in net exports can throw the economy out of exports can throw the economy out of equilibrium and cause national income to equilibrium and cause national income to change.change.


The Federal BudgetThe Federal Budget

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

AMOUNTAMOUNTPERCENTAGE PERCENTAGE

OF TOTALOF TOTAL

ReceiptsReceiptsPersonal taxesPersonal taxes 774.4774.4 44.944.9Corporate taxesCorporate taxes 211.9211.9 12.312.3Indirect business taxesIndirect business taxes 91.391.3 5.35.3Contributions for social insuranceContributions for social insurance 645.9645.9 37.537.5

TotalTotal 1,723.41,723.4 100.0100.0Current ExpendituresCurrent Expenditures

ConsumptionConsumption 463.8463.8 26.526.5Transfer paymentsTransfer payments 795.5795.5 45.445.4Grants-in-aid to state and local governmentsGrants-in-aid to state and local governments 224.2224.2 12.812.8Net interest paymentsNet interest payments 230.3230.3 13.113.1Net subsidies of government enterprisesNet subsidies of government enterprises 38.438.4 2.22.2

TotalTotal 1,752.21,752.2 100.0100.0Current Surplus (+) or deficit (Current Surplus (+) or deficit () ) (Receipts (Receipts Current Expenditures) Current Expenditures) 28.828.8

Source:Source: U.S. Department of Commerce, Bureau of Economic Analysis. U.S. Department of Commerce, Bureau of Economic Analysis.


The Federal Government Surplus/Deficit as The Federal Government Surplus/Deficit as a Percentage of GDP, 1970 Ia Percentage of GDP, 1970 I2000 IV2000 IV


The Federal Government Debt as a The Federal Government Debt as a Percentage of GDP, 1970 IPercentage of GDP, 1970 I2000 IV2000 IV

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


The Economy’s Influence on the The Economy’s Influence on the Government BudgetGovernment Budget

• Tax revenues depend on the state of Tax revenues depend on the state of the economy.the economy.

• Some government expenditures Some government expenditures depend on the state of the economy.depend on the state of the economy.

• Automatic stabilizersAutomatic stabilizers are revenue are revenue and expenditure items in the federal and expenditure items in the federal budget that automatically change budget that automatically change with the state of the economy in such with the state of the economy in such a way as to stabilize a way as to stabilize GDPGDP..



• Fiscal dragFiscal drag is the negative effect on is the negative effect on the economy that occurs when the economy that occurs when average tax rates increase because average tax rates increase because taxpayers have moved into higher taxpayers have moved into higher income brackets during an income brackets during an expansion.expansion.



• The The full-employment budgetfull-employment budget is a is a benchmark for evaluating fiscal benchmark for evaluating fiscal policy.policy.

• The The full-employment budgetfull-employment budget is what is what the federal budget would be if the the federal budget would be if the economy were producing at a full-economy were producing at a full-employment level of output.employment level of output.



• The The cyclical deficitcyclical deficit is the is the deficit that occurs because of deficit that occurs because of a downturn in the business a downturn in the business cycle.cycle.

• The The structural deficitstructural deficit is the is the deficit that remains at full deficit that remains at full employment.employment.


Yb b t

a bT I G

1

1 0( )

Appendix A:Appendix A:The government spending and tax multipliersThe government spending and tax multipliers

• The government spending and tax multipliers when The government spending and tax multipliers when taxes are a function of income are derived as follows:taxes are a function of income are derived as follows:

Y C I G C a b Y T ( )

Y Y Td

I I 0

G G 0

T T tY 0

Y a bY bT btY I G 0

Y bY btY a bT I G 0

Y b b t a bT I G( )1 0

multiplier value of autonomous expenditures


Appendix A: The Balanced-Budget MultiplierAppendix A: The Balanced-Budget Multiplier

• If we combine the effects of the government If we combine the effects of the government spending multiplier and the tax multiplier, we spending multiplier and the tax multiplier, we obtain:obtain:

Y

G M P S=

1and

Y

T

M P C

M P S

Taxmultiplier

Multiplier ofgovernmentspending

11

M P S

M P C

M P S

M P S

M P S

• In words, a simultaneous increase in government In words, a simultaneous increase in government spending by $1 and lump-sum taxes by $1 will spending by $1 and lump-sum taxes by $1 will increase equilibrium income by $1.increase equilibrium income by $1.

then:


Appendix B:Appendix B:The government spending and tax multipliersThe government spending and tax multipliers

• The government spending and tax multipliers are The government spending and tax multipliers are derived algebraically as follows:derived algebraically as follows:

Y C I G C a b Y T ( )

Y Y Td T T 0

I I 0

G G 0

Y a b Y T I G ( )

Y a bY bT I G Y bY a bT I G Y b a bT I G( )1

Yb

a bT I G* ( )

1

1multiplier value of autonomous

expenditures

© 2002 prentice hall business publishingprinciples of economics, 6/ekarl case, ray fair government...

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