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The Government
and Fiscal Policy
OUTLINE
Government in the Economy
Government Purchases (G), Net Taxes (T),
and Disposable income (Y
d
)
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 2007
Fiscal Policy Since 1993: The Clinton and Bush
Administrations
The Federal Government Debt
The Economys 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
The Government and Fiscal
Policy
fiscal policy The governments
spending and taxing policies.
monetary policy The behavior
of the BSP concerning the
nations money supply.
The behavior of the BSP concerning
the nations money supply is called:
a. Discretionary fiscal policy.
b. Automatic fiscal policy.
c. Budgetary policy.
d. Monetary policy.
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The behavior of the Central Bank
concerning the nations money
supply is called:
a. Discretionary fiscal policy.
b. Automatic fiscal policy.
c. Budgetary policy.
d. d. Monetary policy. Monetary policy.
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Government in the Economy
discretionary fiscal policy Changes in
taxes or spending that are the result of
deliberate changes in government policy.
net taxes (T) Taxes paid by firms and households to
the government minus transfer payments made to
households by the government.
disposable, or after-tax, income (Y
d
) Total income
minus net taxes: Y - T.
Government Purchases (G), Net Taxes (T), and
Disposable Income (Y
d
)
disposable income total income net taxes
Y
d
Y T
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Over which of the following categories
does the government have more
control?
a. Tax revenue.
b. Government expenditures.
c. Tax rates.
d. The size of corporate profits.
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Over which of the following categories
does the government have more
control?
a. Tax revenue.
b. Government expenditures.
c. c. Tax rates. Tax rates.
d. The size of corporate profits.
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Government in the Economy
Government Purchases (G), Net Taxes (T),
and Disposable Income (Y
d
)
FIGURE .1 Adding
Net Taxes (T) and
Government
Purchases (G) to the
Circular Flow of
Income
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Select the best answer. Households
use their disposable income (Y
d
) to
do the following:
a. Consume.
b. Consume and save.
c. Consume, save, and pay taxes.
d. Consume, save, pay taxes, and buy
imports.
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Select the best answer. Households
use their disposable income (Y
d
) to
do the following:
a. Consume.
b. b. Consume and save. Consume and save.
c. Consume, save, and pay taxes.
d. Consume, save, pay taxes, and buy
imports.
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Government in the Economy
Government Purchases (G), Net Taxes (T), and
Disposable Income (Y
d
)
When government enters the picture, the
aggregate income identity gets cut into
three pieces:
Y Y T
d
Y C S
d
+
Y T C S +
Y C S T + +
And aggregate expenditure (AE) equals:
AE C I G = + +
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Government in the Economy
Government Purchases (G), Net Taxes (T), and Disposable Income
(Y
d
)
budget deficit The difference between 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
Government Purchases (G), Net Taxes (T), and Disposable Income (Y
d
)
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 + bY
d
C = a + b(Y T)
Our consumption function now has consumption depending on
disposable income instead of before-tax income.
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When government enters the circular
flow of income, which of the
following is an expression for
planned aggregate expenditure?
a. Y T
b. C + S + T
c. C + I + G
d. G T
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When government enters the circular
flow of income, which of the
following is an expression for
planned aggregate expenditure?
a. Y T
b. C + S + T
c. C + I + G C + I + G
d. G T
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Government in the Economy
Government Purchases (G), Net Taxes (T), and Disposable Income (Y
d
)
Planned Investment
The government can affect
investment behavior through its
tax treatment of depreciation and
other tax policies.
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AGGREGATE OUTPUT AND
AGGREGATE INCOME (Y)
aggregate output The total quantity of goods and
services produced in an economy in a given period.
aggregate income The total income received by all
factors of production in a given period.
aggregate output (income) (Y) A combined term
used to remind you of the exact equality between
aggregate output and aggregate income.
In any given period, there is an exact equality between
aggregate output (production) & aggregate income. You
should be reminded of this fact whenever you encounter the
combined term aggregate output (income) (Y).
Important to Note:
This session presents the basic Keynesian
macroeconomic model
The Keynesian model assumes that producers
meet demand at preset prices.
All of the adjustment is quantity
The shortcoming of their assumption is that it
does not explain changes in prices and inflation.
Think in Real Terms
When we talk about output (Y), we mean
real output (real GDP), not nominal output
(P x Y).
The main point is to think of Y as being in
real termsthe quantities of goods &
services produced, not the dollars/pesos
circulating in the economy.
Another Important Note:
Saving Aggregate Income Consumption
INCOME, CONSUMPTION, AND SAVING
(Y, C, AND S)
AGGREGATE OUTPUT AND
AGGREGATE INCOME (Y)
saving (S) The part of its income that a
household does not consume in a given period.
Distinguished from savings,
which is the current stock of accumulated saving.
Saving income consumption
S Y C
identity Something that is always true.
NOTE on Stocks & Flows
We distinguish between economics
concepts that are stocks or flows
Flow concepts are per unit of time
Stock concepts have no time element
Income (Y), consumption (C) and saving
(S) are flow concepts Why?
Savings, wealth, money in your bank
account, the level of employment are stock
concepts Why?
What is the government deficit?
What is the level of the national debt?
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AGGREGATE OUTPUT AND
AGGREGATE INCOME (Y)
Household Consumption and Saving
Things that determine aggregate consumption include:
1. Household income (direct, positive)
2. Household wealth (direct, positive)
3. Interest rates (negative)
4. Households expectations about the future
(expectations about what?)
The higher your income is, the higher your
consumption is likely to be. People with more income
tend to consume more than people with less income.
consumption function The relationship bet. consumption &
income.
The Keynesian Theory of Consumption
consumption function The relationship between
consumption and income.
A Consumption
Function for a
Household
A consumption
function for an
individual
household shows
the level of
consumption at
each level of
household
income.
The Keynesian Theory of Consumption
With a straight line consumption curve, we can use
the following equation to describe the curve:
C = a + bY
An Aggregate
Consumption Function
The aggregate
consumption function
shows the level of
aggregate consumption at
each level of aggregate
income.
The upward slope
indicates that higher
levels of income lead to
higher levels of
consumption spending.
Because the aggregate consumption function is a straight
line, we can write the following equation to describe it:
C = a + bY
marginal propensity to consume (MPC) That fraction of a change
in income that is consumed, or spent. The slope (b) of the
consumption function is the MPC.
Y
C
actual investment
aggregate income
aggregate output
aggregate output
(income) (Y)
autonomous variable
change in inventory
consumption function
desired, or planned,
investment
equilibrium
identity
investment
REVIEW TERMS AND CONCEPTS
marginal propensity to consume (MPC)
marginal propensity to save (MPS)
multiplier
paradox of thrift
planned aggregate expenditure (AE)
saving (S)
1. S Y C
2.
3. MPC + MPS 1
4. AE C + I
5. Equilibrium condition: Y = AE or Y = C + I
6. Saving/investment approach to
equilibrium: S = I
7.
function n consumptio of slope
Y
C
MPC
= =
- MPC MPS 1
1
1
Multiplier
DERIVING THE MULTIPLIER ALGEBRAICALLY
Appendix
Recall that our consumption function is:
C = a + bY
where b is the marginal propensity to consume. In equilibrium:
Y = C + I
Now we solve these two equations for Y in terms of I. By
substituting the first equation into the second, we get:
I bY a Y
C
+ + =
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DERIVING THE MULTIPLIER ALGEBRAICALLY
Appendix
This equation can be rearranged to yield:
Y bY = a + I
Y(1 b) = a + I
We can then solve for Y in terms of I by dividing through by
(1 b):
+ =
b
I a Y
1
1
) (
DERIVING THE MULTIPLIER ALGEBRAICALLY
Appendix
Now look carefully at this expression and think about
increasing I by some amount, I, with a held constant.
If I increases by I, income will increase by
Because b MPC, the expression becomes
b
I Y
=
1
1
MPC
I Y
=
1
1
DERIVING THE MULTIPLIER ALGEBRAICALLY
Appendix
The multiplier is
Finally, because MPS + MPC 1, MPS is equal to 1 MPC,
making the alternative expression for the multiplier 1/MPS,
just as we saw in this chapter.
MPC 1
1
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DERIVING THE FISCAL POLICY MULTIPLIERS
A P P E N D I X
THE GOVERNMENT SPENDING AND TAX MULTIPLIERS
Y C I G = + +
C a b Y T = + ( )
Y a b Y T I G = + + + ( )
Y a bY bT I G = + + +
Y bY a I G bT = + +
Y b a I G bT ( ) 1 = + +
( )
) (
1
1
bT G I a
b
Y + +
=
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DERIVING THE FISCAL POLICY MULTIPLIERS
THE BALANCED-BUDGET MULTIPLIER
The balanced-budget multiplier is
found by combining the effects of
government spending and taxes:
G increase in spending:
( ) C T MPC = - decrease in spending:
( ) G T MPC = net increase in spending
In a balanced-budget increase, G = T;
so we can substitute:
net initial increase in spending:
G G (MPC) = G (1 MPC)
A P P E N D I X
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DERIVING THE FISCAL POLICY MULTIPLIERS
THE BALANCED-BUDGET MULTIPLIER
A P P E N D I X
1
( ) Y G MPS G
MPS
= =
Because MPS = (1 MPC), the net
initial increase in spending is:
G (MPS)
We can now apply the expenditure multiplier
to this net initial increase in spending:
MPS
1
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THE CASE IN WHICH TAX REVENUES DEPEND ON INCOME
A P P E N D I X
T Y Y
d
) 3 / 1 200 ( Y Y Y
d
+
Y Y Y
d
3 / 1 200 +
d
Y C 75 . 100+ =
) 3 / 1 200 ( 75 . 100 Y Y C + + =
FIGURE 24B.1 The
Tax Function
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THE CASE IN WHICH TAX REVENUES DEPEND ON INCOME
A P P E N D I X
When taxes are strictly lump-
sum (T = 100) and do not
depend on income, the
aggregate expenditure function
is steeper than when taxes
depend on income.
FIGURE 24B.2
Different Tax Systems
G I C Y + + =
100 .75( 200 1/ 3 ) 100 100 Y Y Y
I G
C
= + + + +
450 5 .
5 . 450
100 100 25 . 150 75 . 100
=
+ =
+ + + + =
Y
Y Y
Y Y Y
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THE CASE IN WHICH TAX REVENUES DEPEND ON INCOME
A P P E N D I X
THE GOVERNMENT SPENDING AND TAX MULTIPLIERS ALGEBRAICALLY
C a b Y T = + ( )
0
C a bY bT btY = +
0
( ) C a b Y T tY = +
0
Y a bY bT btY I G
C
= + + +
Y
b bt
a I G bT =
+
+ +
1
1
0
( )
1
1 b bt +