The Government and

Fiscal Policy 9
CHAPTER OUTLINE
Government in the Economy
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 2012
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
LookingAhead
Appendix A: Deriving the Fiscal PolicyMultipliers
Appendix B: The Case in Which TaxRevenues
Depend on Income
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 Government in the economy
 The government can affect the economy through two
policies:
1- Monetary Policy: is the decision of the central bank to
change the total money supply.

In time of high unemployment (recession or slump) the

central bank adopts an expansionary monetary policy (MS )

In time of inflation (boom) the central bank adopts a

contractionary monetary policy (MS ).
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Government in the economy
2. Fiscal Policy: The government can affect the economy through
two policies;

 The government’s spending

Gov. Expenditure (G): includes all government purchases of goods &
services.

 Taxing policies.
Net Taxes (T): Taxes paid by firms and households to the
government minus transfer payments made to households by the
government(such as unemployment compensation, Social
Security benefits, welfare payments, and veterans’ benefits)

Net Taxes (T) = taxes – government transfer payments.

Government in the economy
 FIGURE 9.1 Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of
Income

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 Government Purchases (G ), Net Taxes (T ), and Disposable
Income (Yd)
Disposable, or after-tax, income (Yd) Total income minus net taxes: Y − T.

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

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The Determination of Equilibrium Output (Income) in a closed
Economy with Government

Under a closed economy with government, the equilibrium level of

output (GDP or income) can be determined using two approaches:

(1) Aggregate approach:

Output (Supply) = Planned aggregate expenditure ( Demand )

(2) Saving- Investment approach:

 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.

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Example
 The Determination of Equilibrium Output (Income)

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 Yd ≡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 ↓

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 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.

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 Fiscal Policy at Work: Multiplier Effects
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

The Government Spending Multiplier

1 1
government spending multiplier  
MPS 1 MPC

government spending multiplier The ratio of the change in the equilibrium

level of output to a change in government spending.

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 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 ↑

500 100 400 400 0 100 150 650  150 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 ↓

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 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.

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 The Tax Multiplier
Measures the change in output resulted from change in tax

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  
 MPC
MPS

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 The Balanced-Budget Multiplier

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

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 TABLE 9.4 Summary of Fiscal Policy Multipliers
Final Impact on
Policy Stimulus Multiplier Equilibrium Y
Government 1 1
spending G 
multiplier
MPS MPS

Tax multiplier  MPC  MPC

T 
MPS MPS

Balanced-
budget 1 G
multiplier

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 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 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 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 ↓

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 Home work
Consider the previous example,
A. If the government spending increase of $40 billion, with taxes (T) held
constant.
1. Find the government spending multiplier.
2. Find the new equilibrium level of income.

B. Adding 40 Tax,
1. Find the tax multiplier
2. Find the new equilibrium level of income

C. If the government spending increase of $40 billion, and tax increase by 40,
what is the net effect on the equilibrium level of income.

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