Chapter

22
The Government
and Fiscal Policy

Prepared by:

Fernando & Yvonn Quijano

© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
 The Government
and Fiscal Policy 22
and Fiscal Policy
CHAPTER 22: The Government

Chapter Outline
Government in the Economy
Government Purchases (G), Net Taxes (T), and
Disposable income (Yd)
Equilibrium Output: Y = C + I + G
Fiscal Policy at Work: Multiplier Effects
The Government Spending Multiplier
The Tax Multiplier
The Balanced-Budget Multiplier
The Federal Budget
The Budget
The Surplus or Deficit
The Debt
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
Fiscal Drag
Full-Employment Budget
Looking Ahead
Appendix A: Deriving the Fiscal Policy Multipliers
Appendix B: The Case in Which Tax Revenues
Depend on Income
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 THE GOVERNMENT AND FISCAL POLICY

fiscal policy The government’s

spending and taxing policies.
and Fiscal Policy
CHAPTER 22: The Government

monetary policy The behavior of the

Federal Reserve concerning the nation’s
money supply.

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 GOVERNMENT IN THE ECONOMY

discretionary fiscal policy Changes in

taxes or spending that are the result of
and Fiscal Policy
CHAPTER 22: The Government

deliberate changes in government

policy.

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 GOVERNMENT IN THE ECONOMY

GOVERNMENT PURCHASES (G), NET TAXES (T),

AND DISPOSABLE INCOME (YD)
and Fiscal Policy
CHAPTER 22: The Government

net taxes (T) Taxes paid by firms and

households to the government minus
transfer payments made to households
by the government.

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 GOVERNMENT IN THE ECONOMY
and Fiscal Policy
CHAPTER 22: The Government

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

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 GOVERNMENT IN THE ECONOMY

disposable, or after-tax, income (Yd)

Total income minus net taxes: Y − T.
and Fiscal Policy
CHAPTER 22: The Government

disposable income ≡ total income − net taxes

Yd ≡ Y − T

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 GOVERNMENT IN THE ECONOMY

When government enters the picture, the aggregate

income identity gets cut into three pieces:
and Fiscal Policy
CHAPTER 22: The Government

And aggregate expenditure (AE) equals:

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 GOVERNMENT IN THE ECONOMY

budget deficit The difference between

and Fiscal Policy
CHAPTER 22: The Government

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 IN THE ECONOMY

Adding Taxes to the Consumption Function

and Fiscal Policy

To modify our aggregate consumption function to

CHAPTER 22: The Government

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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 GOVERNMENT IN THE ECONOMY

Investment
and Fiscal Policy

The government can affect investment behavior

CHAPTER 22: The Government

through its tax treatment of depreciation and other

tax policies.

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 GOVERNMENT IN THE ECONOMY

EQUILIBRIUM OUTPUT: Y = C + I + G

equilibrium condition: Y = C + I + G
and Fiscal Policy
CHAPTER 22: The Government

TABLE 9.1 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  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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 GOVERNMENT IN THE ECONOMY
and Fiscal Policy
CHAPTER 22: The Government

FIGURE 9.2 Finding Equilibrium Output/Income Graphically

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 GOVERNMENT IN THE ECONOMY (see other
slide)

The Leakages/Injections Approach to Equilibrium

Taxes (T) are a leakage from the flow of income. Saving

and Fiscal Policy
CHAPTER 22: The Government

(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,

leakages/injections approach to equilibrium: S + T = I + G

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 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,
and Fiscal Policy
CHAPTER 22: The Government

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 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,
and Fiscal Policy
CHAPTER 22: The Government

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 FISCAL POLICY AT WORK:
MULTIPLIER EFFECTS

THE GOVERNMENT SPENDING MULTIPLIER

TABLE 9.2 Finding Equilibrium After a $50 Billion Government Spending

and Fiscal Policy
CHAPTER 22: The Government

Increase (All Figures in Billions of Dollars; G Has Increased from 100

in Table 9.1 to 150 Here)
(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  50 100 150 500  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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 FISCAL POLICY AT WORK:
MULTIPLIER EFFECTS
and Fiscal Policy
CHAPTER 22: The Government

government spending multiplier

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

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 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.
and Fiscal Policy
CHAPTER 22: The Government

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 FISCAL POLICY AT WORK:
MULTIPLIER EFFECTS
and Fiscal Policy
CHAPTER 22: The Government

FIGURE 9.3 The Government Spending Multiplier

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 FISCAL POLICY AT WORK:
MULTIPLIER EFFECTS

THE TAX MULTIPLIER

and Fiscal Policy
CHAPTER 22: The Government

The multiplier for a change in taxes is not the same as the multiplier for a change in
government spending.

tax multiplier The ratio of change in

the equilibrium level of output to a
change in taxes.

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 FISCAL POLICY AT WORK:
MULTIPLIER EFFECTS
and Fiscal Policy
CHAPTER 22: The Government

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 The Tax Multiplier
and Fiscal Policy
CHAPTER 22: The Government

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 FISCAL POLICY AT WORK:
MULTIPLIER EFFECTS

THE BALANCED-BUDGET MULTIPLIER

balanced-budget multiplier The ratio

and Fiscal Policy
CHAPTER 22: The Government

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 is exactly the same
size as the initial change in G or T
itself.
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 FISCAL POLICY AT WORK:
MULTIPLIER EFFECTS
and Fiscal Policy
CHAPTER 22: The Government

An increase in government spending has a direct initial effect on planned aggregate

expenditure; a tax increase does not. The initial effect of the tax increase is that
households cut consumption by the MPC times the change in taxes. This change in
consumption is less than the change in taxes, because the MPC is less than 1. The
positive stimulus from the government spending increase is thus greater than the
negative stimulus from the tax increase. The net effect is that the balanced-budget
multiplier is 1.
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 FISCAL POLICY AT WORK:
MULTIPLIER EFFECTS

TABLE 9.3 Finding Equilibrium After a $200-Billion Balanced-Budget Increase

in G and T (All Figures in Billions of Dollars; Both G and T Have
Increased from 100 in Table 9.1 to 300 Here)
and Fiscal Policy
CHAPTER 22: The Government

(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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 FISCAL POLICY AT WORK:
MULTIPLIER EFFECTS (see other slide)

TABLE 9.4 Summary of Fiscal Policy Multipliers

FINAL IMPACT ON
and Fiscal Policy
CHAPTER 22: The Government

POLICY STIMULUS MULTIPLIER EQUILIBRIUM Y

Government- Increase or decrease in the

spending level of government
multiplier purchases:

Tax multiplier Increase or decrease in the

level of net taxes:

Balanced- Simultaneous balanced-budget

budget increase or decrease in the
1
multiplier level of government purchases
and net taxes:

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 Fiscal Policy Multipliers

Summary of Fiscal Policy Multipliers

and Fiscal Policy
CHAPTER 22: The Government

FINAL IMPACT ON
POLICY STIMULUS MULTIPLIER EQUILIBRIUM Y

Government- Increase or decrease in the

spending level of government
multiplier purchases:

Tax multiplier Increase or decrease in the

level of net taxes:

Balanced- Simultaneous balanced-budget

budget increase or decrease in the
1
multiplier level of government purchases
and net taxes:

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 THE FEDERAL BUDGET

federal budget The budget of the

federal government.
and Fiscal Policy
CHAPTER 22: The Government

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 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 (-).
and Fiscal Policy
CHAPTER 22: The Government

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 THE FEDERAL BUDGET
THE BUDGET
TABLE 9.5 Federal Government Receipts and Expenditures, 2004 (Billions of
Dollars)
PERCENTAGE
AMOUNT OF TOTAL
and Fiscal Policy
CHAPTER 22: The Government

Receipts
Personal income taxes 801.8 40.6
Excise taxes and custom duties 94.0 4.8
Corporate income taxes 217.4 11.0
Taxes from the rest of the world 9.2 0.5
Contributions for social insurance 802.5 40.6
Interest receipts and rents and royalties 21.9 1.1
Current transfer receipts from business and persons 28.6 1.4
Current surplus of government enterprises − 0.5 0.0
Total 1,974.8 100.0
Current Expenditures
Consumption expenditures 725.7 30.5
Transfer payments to persons 1,014.0 42.6
Transfer payments to the rest of the world 28.9 1.2
Grants-in-aid to state and local governments 348.3 14.6
Interest payments 221.5 9.3
Subsidies 43.0 1.8
Total 2,381.3 100.0
Net federal government saving—surplus (+) or deficit (−)
(total current receipts − total current expenditures) − 406.5
Source: U.S. Department of Commerce, Bureau of Economic Analysis.

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 THE FEDERAL BUDGET

THE SURPLUS OR DEFICIT

federal surplus (+) or deficit (−) Federal

government receipts minus expenditures.
and Fiscal Policy
CHAPTER 22: The Government

FIGURE 9.4 The Federal Government Surplus (+) or Deficit (−) as a

Percentage of GDP, 1970 I–2005 II
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 THE FEDERAL BUDGET

THE DEBT
and Fiscal Policy
CHAPTER 22: The Government

federal debt The total amount owed

by the federal government.

privately held federal debt The

privately held (nongovernment-
owned) debt of the U.S. government.

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 THE FEDERAL BUDGET
and Fiscal Policy
CHAPTER 22: The Government

FIGURE 9.5 The Federal Government Debt as a Percentage of GDP, 1970 I–2005 II

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 THE ECONOMY’S INFLUENCE
ON THE GOVERNMENT BUDGET

TAX REVENUES DEPEND ON THE STATE OF

THE ECONOMY
and Fiscal Policy
CHAPTER 22: The Government

Tax revenue depends on taxable income, and

income depends on the state of the economy,
which the government does not control.

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 THE ECONOMY’S INFLUENCE
ON THE GOVERNMENT BUDGET

SOME GOVERNMENT EXPENDITURES DEPEND

ON THE STATE OF THE ECONOMY
and Fiscal Policy
CHAPTER 22: The Government

Transfer payments tend to go down

automatically during an expansion.

Inflation often picks up when the economy is

expanding. This can lead the government to
spend more than it had planned to spend.

Any change in the interest rate changes

government interest payments.

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 THE ECONOMY’S INFLUENCE
ON THE GOVERNMENT BUDGET

AUTOMATIC STABILIZERS
and Fiscal Policy
CHAPTER 22: The Government

automatic stabilizers 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.

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 THE ECONOMY’S INFLUENCE
ON THE GOVERNMENT BUDGET

FISCAL DRAG
and Fiscal Policy
CHAPTER 22: The Government

fiscal drag The negative effect on

the economy that occurs when
average tax rates increase because
taxpayers have moved into higher
income brackets during an
expansion.

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 THE ECONOMY’S INFLUENCE
ON THE GOVERNMENT BUDGET

FULL-EMPLOYMENT BUDGET

full-employment budget What the

and Fiscal Policy
CHAPTER 22: The Government

federal budget would be if the

economy were producing at a full-
employment level of output.

structural deficit The deficit that

remains at full employment.

cyclical deficit The deficit that

occurs because of a downturn in the
business cycle.

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 REVIEW TERMS AND CONCEPTS
automatic stabilizers net taxes (T)
balanced-budget multiplier privately held federal debt
budget deficit structural deficit
cyclical deficit tax multiplier
and Fiscal Policy
CHAPTER 22: The Government

discretionary fiscal policy 1. Disposable income Yd ≡ Y − T

disposable, or after-tax, 2. AE ≡ C + I + G
income (Yd) 3. Government budget deficit ≡ G − T
federal budget 4. Equilibrium in an economy with
federal debt government: Y = C + I + G
federal surplus (+) or 5. Leakages/injections approach to
deficit (−) equilibrium in an economy with
fiscal drag government: S + T = I + G
fiscal policy 6. Government spending multiplier ≡
full-employment budget
government spending 7. Tax multiplier ≡
multiplier
monetary policy
8. Balanced-budget multiplier ≡ 1
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 Appendix A

DERIVING THE FISCAL POLICY MULTIPLIERS

THE GOVERNMENT SPENDING AND TAX
MULTIPLIERS
and Fiscal Policy
CHAPTER 22: The Government

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 Appendix A:
Deriving the Fiscal Policy Multipliers

The government spending and tax multipliers algebraically:

and Fiscal Policy
CHAPTER 22: The Government

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 Appendix A

THE BALANCED-BUDGET MULTIPLIER

The balanced-budget multiplier is found by combining
the effects of government spending and taxes:
and Fiscal Policy
CHAPTER 22: The Government

increase in spending:
- decrease in
spending:
= net increase in spending

In a balanced-budget increase, ΔG = ΔT, so we can

substitute:

net initial increase in spending:

ΔG − ΔG (MPC) = ΔG (1 − MPC)

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 Appendix A:
Deriving the Fiscal Policy Multipliers

The balanced-budget multiplier is found by combining the effects of government spending and taxes:
and Fiscal Policy
CHAPTER 22: The Government

increase in spending:
- decrease in spending:

= net increase in spending

• The balanced-budget multiplier

equals one. An increase in G
and T by one dollar each causes
a one-dollar increase in Y.
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 Appendix A

Because MPS = (1 − MPC), the net initial increase in

spending is:
and Fiscal Policy
CHAPTER 22: The Government

ΔG (MPS)

We can now apply the expenditure multiplier

to this net initial increase in spending:

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 Appendix B

THE CASE IN WHICH TAX REVENUES DEPEND ON

INCOME
and Fiscal Policy
CHAPTER 22: The Government

FIGURE 9B.1 The Tax Function

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 Appendix B
and Fiscal Policy
CHAPTER 22: The Government

FIGURE 9B.2 Different Tax Systems

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 Appendix B

THE GOVERNMENT SPENDING AND TAX

MULTIPLIERS ALGEBRAICALLY
and Fiscal Policy
CHAPTER 22: The Government

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