The Government and Fiscal Policy

1. The Governmentand Fiscal Policy Appendix A: Deriving the Fiscal Policy Multipliers Appendix B: The Case in Which Tax Revenues Depend on Income Prepared by: Fernando Quijano and Yvonn Quijano

2. Government in the Economy There is much controversy over the appropriate role government should play in the economy. This controversy constantly shifts between positive and normative arguments. 1. Keynesians believe that the macroeconomy is likely to fluctuate too much if left on its own.

3. Government in the Economy 2. Others (known by the classical school) claim that fiscal and monetary policies are incapable of stabilizing the economy and, even worse, may be destabilizing and harmful. Most agree, however, that governments are important actors in the economy.

4. The government can affect the macroeconomy through fiscal policy (its spending and taxing behavior) and monetary policy (the behavior of the Federal Reserve regarding the nation’s money supply). 1. Fiscal policy includes changes in government purchases of goods and labor, taxes, and/or transfer payments to households with the objective of changing the economy’s growth.

5. 2. Monetary policy means changes in the quantity of money in circulation with the objective of changing the economy’s growth. Often monetary policy is set as an interest rate target

6. Government in the Economy We need to distinguish between variables that the government controls directly and those that are a consequence of government decisions. 1. For example, government controls tax rates, but tax revenues are also affected by the state of the economy.

7. Government in the Economy 2. Similarly, government spending also depends both on government decisions and on the state of the economy. For example, government spending for unemployment compensation increases when the economy moves into a recession and the unemployment rate rises.

8. Net Taxes (T), and Disposable Income (Yd) • Discretionary fiscal policy refers to any change in taxes or spending that is intended to influence the future path of the economy. • Net taxes= 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.

9. Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income

10. 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: • And aggregate expenditure (AE) equals:

11. 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: • 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.

12. Adding Taxes to theConsumption Function • The aggregate consumption function is now a function of disposable, or after-tax, income. • What about investment? The government can affect investment behavior through the following: • Tax policies. • interest rates. • For our present purposes, we continue to assume that planned investment (I) is independent variable.

13. Equilibrium Output: Y = C + I + G

14. Finding EquilibriumOutput/Income Graphically

15. 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,

16. The Government Spending Multiplier • TheGovernment Spending Multiplieris defined as the ratio of the change in the equilibrium level of output to a change in government spending. This is the same definition we used in the previous chapter, but now the independent variable is government spending instead of planned investment. Government Multiplier = ∆ y / ∆ G

17. The Government Spending Multiplier G output income employment spending output again income This is the government multiplier

18. The Government Spending Multiplier • 1. How can the government use taxing and spending policy to increase the equilibrium level of national output? • 2. Increased government spending will lead to increased output, which leads to increased income. More workers are employed, and they in turn act as consumers and spend their incomes. • 3. Output will rise again and so will income, etc. This is the multiplier in action. The government spending multiplier is the same as the investment multiplier.

19. The Government Spending Multiplier

20. The Government Spending Multiplier

21. The Tax Multiplier Tax Yd consumption spending employment output and income This is the tax multiplier

22. The Tax Multiplier • The tax multiplier is the ratio of the change in equilibrium income to a change in taxes. • To reduce unemployment without increasing government spending, taxes must be cut. This increases disposable income, which is likely to add to consumption, which will lead to an increase in output and employment, and hence income, etc. Government Taxes Multiplier = ∆ y / ∆ T

23. The Tax Multiplier • A tax cut increases disposable income, and leads to added consumption spending. Income will increase by a multiple of the decrease in taxes. • The multiplier for a change in taxes is smaller than the multiplier for a change in government spending. Government Taxes Multiplier ˂ Government Spending Multiplier

24. The Tax Multiplier ∆ y / ∆ T = ( - MPC / MPS ) ∆ y =

25. Adding the International Sector • Opening the economy to foreign trade adds a fourth component to planned aggregate expenditure—exports of goods and services, or EX. Exports are foreign purchases of goods and services produced in the United States. Opening the economy to the rest of the world also means that U.S. consumers and businesses have greater choice because they can buy foreign-produced goods and services (imports, or IM) in addition to domestically produced goods and services. • We can think of imports (IM) as a leakage from the circular flow and exports (EX) as an injection into the circular flow. (Review Figure 5.1.) With imports and exports, the equilibrium condition for the economy is: • open-economy equilibrium: Y = C + I + G + (EX - IM)

26. 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. Balanced-budget multiplier is ∆ y / ∆ G when ∆ G = ∆ T

27. The Balanced-Budget Multiplier • The balanced-budget multiplier = Government Spending multiplier + Tax multiplier So, the balanced-budget multiplier = 1

28. The Balanced-Budget Multiplier

29. The Balanced-Budget Multiplier • To understand the idea : • The equilibrium Y was 900. suppose the Government Spending (G) increased by $200 billions and the government taxes increased by $200 billions at the same time what will occur to the equilibrium Y.

30. The Balanced-Budget Multiplier Answer: First:Government Spending Multiplier is ∆ y / ∆ G = 1 / MPS ∆ y = ∆ G / MPS ∆ y = 200 / 0.25 ∆ y = 800 Second:Government Taxes Multiplier is ∆ y / ∆ T = - MPC / MPS ∆ y = ∆ T (- MPC / MPS) ∆ y = 200( - 0.75 / 0.25) ∆ y = - 600

31. The Balanced-Budget Multiplier • So the final change in equilibrium Y = 800 – 600 = $ 200 billion • This means the ∆ Y = ( 1 x ∆ G ), which means • ∆ Y = ( 1 x 200 ) = 200 • The balanced budget multiplier = 1

32. Fiscal Policy Multipliers

33. The Federal Budget • The federal budget is the budget of the federal government. • The difference between the federal government’s receipts and its expenditures is the federal surplus (+) or deficit (-).

34. The Federal Budget

35. The Federal Government Surplus (+) or Deficit (-) as a Percentage of GDP, 1970 I-2003 II

36. The Debt • The federal debt is the total amount owed by the federal government. The debt is the sum of all accumulated deficits minus surpluses over time. • Some of the federal debt is held by the U.S. government itself and some by private individuals. The privately held federal debt is the private (non-government-owned) portion of the federal debt.

37. The Federal Government Debt as a Percentage of GDP, 1970 I-2003 II The percentage began to fall in the mid 1990s.

38. The Economy’s Influenceon the Government Budget • 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.

39. The Economy’s Influenceon the Government Budget • Fiscal drag (السحب المالي ) 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. • The full-employment budget is what the federal budget would be if the economy were producing at a full-employment level of output.

40. The Economy’s Influenceon the 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.

41. automatic stabilizers balanced-budget multiplier budget deficit cyclical deficit discretionary fiscal policy disposable, or after-tax, income federal budget federal debt federal surplus (+) or deficit (-) fiscal drag fiscal policy full-employment budget government spending multiplier monetary policy net taxes privately held federal debt structural deficit tax multiplier Review Terms and Concepts

42. Appendix A:Deriving the Fiscal Policy Multipliers The government spending and tax multipliers algebraically:

43. increase in spending: - decrease in spending: = net increase in spending Appendix A:Deriving the Fiscal Policy Multipliers • The balanced-budget multiplier is found by combining the effects of government spending and taxes: • The balanced-budget multiplier equals one. An increase in G and T by one dollar each causes a one-dollar increase in Y.

44. Appendix B: The Case In WhichTax Revenues Depend on Income

45. Appendix B: The Case In WhichTax Revenues Depend on Income

46. Appendix B: The Case In WhichTax Revenues Depend on Income The Government Spending and Tax Multipliers Algebraically:

47. Appendix B: The Case In WhichTax Revenues Depend on Income • The government spending and tax multipliers when taxes are a function of income are derived as follows: