CHAPTER
21
The Government
and 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
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 21: The Government and Fiscal Policy
Government in the Economy
• Nothing arouses as much controversy as
the role of government in the economy.
• Government can affect the macroeconomy
in two ways:
• Fiscal policy is the manipulation of
government spending and taxation.
• Monetary policy refers to the behavior of the
Federal Reserve regarding the nation’s money
supply.
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C H A P T E R 21: The Government and Fiscal Policy
Government in the Economy
• Discretionary fiscal policy refers to
deliberate changes in taxes or spending.
• The government can not control certain
aspects of the economy related to fiscal
policy. For example:
• The government can control tax rates but not
tax revenue. Tax revenue depends on
household income and the size of corporate
profits.
• Government spending depends on government
decisions and the state of the economy.
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C H A P T E R 21: The Government and Fiscal Policy
Net Taxes (T), and Disposable Income (Yd)
• Net taxes are 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.
Yd  Y  T
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C H A P T E R 21: The Government and Fiscal Policy
Adding Net Taxes (T) and Government
Purchases (G) to the Circular Flow of Income
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C H A P T E R 21: The Government and Fiscal Policy
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:
Yd  Y  T
Yd  C  S
Y  T  C S
Y  C S  T
• And aggregate expenditure (AE) equals:
AE  C  I  G
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C H A P T E R 21: The Government and Fiscal Policy
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:
Budget deficit  G  T
• 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.
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C H A P T E R 21: The Government and Fiscal Policy
Adding Taxes to the
Consumption Function
C  a  bYd
Yd  Y  T
C  a  b( Y  T )
• The aggregate consumption function
is now a function of disposable, or
after-tax, income.
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C H A P T E R 21: The Government and Fiscal Policy
Equilibrium Output: Y = C + I + G
C  100 .75Yd
C  100.75(Y  T )
Finding Equilibrium for I = 100, G = 100, and T = 100
(All Figures in Billions of Dollars)
(1)
(2)
(3)
DISPOSABLE
OUTPUT
NET
INCOME
(INCOME) TAXES
Yd / Y  T
Y
T
(4)
CONSUMPTION
SPENDING
(C = 100 + .75 Yd)
(5)
(6)
(7)
(8)
(9)
(10)
PLANNED
PLANNED
UNPLANNED
SAVING INVESTMENT GOVERNMENT AGGREGATE INVENTORY ADJUSTMENT
S
SPENDING PURCHASES EXPENDITURE
CHANGE
TO
(Yd – C)
I
G
C+I+G
Y  (C + I + G) DISEQUILIBRIUM
300
100
200
250
 50
100
100
450
 150
Output8
500
100
400
400
0
100
100
600
 100
Output8
700
100
600
550
50
100
100
750
 50
Output8
900
100
800
700
100
100
100
900
0
1,100
100
1,000
850
150
100
100
1,050
+ 50
Output9
1,300
100
1,200
1,000
200
100
100
1,200
+ 100
Output9
1,500
100
1,400
1,150
250
100
100
1,350
+ 150
Output9
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Karl Case, Ray Fair
Equilibrium
9 of 35
C H A P T E R 21: The Government and Fiscal Policy
Finding Equilibrium
Output/Income Graphically
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C H A P T E R 21: The Government and Fiscal Policy
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,
AE  C  I  G
Y  C S  T
C S  T  C I  G
S T  I  G
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C H A P T E R 21: The Government and Fiscal Policy
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.
1
Government spending multiplier 
MPS
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C H A P T E R 21: The Government and Fiscal Policy
The Government Spending Multiplier
Finding Equilibrium After a $50 Billion Government Spending Increase
(All Figures in Billions of Dollars; G Has Increased From 100 in Table 25.1 to 150 Here)
(1)
(2)
(3)
(4)
OUTPUT
NET DISPOSABLE CONSUMPTION
INCOME
(INCOME) TAXES
SPENDING
Yd / Y  T (C = 100 + .75 Yd)
Y
T
(5)
(6)
(7)
(8)
(9)
(10)
PLANNED
PLANNED
UNPLANNED
SAVING INVESTMENT GOVERNMENT AGGREGATE INVENTORY
ADJUSTMENT
S
SPENDING
PURCHASES EXPENDITURE
CHANGE
TO
(Yd – C)
I
G
C+I+G
Y  (C + I + G) DISEQUILIBRIUM
300
100
200
250
 50
100
150
500
 200
Output8
500
100
400
400
0
100
150
650
 150
Output8
700
100
600
550
50
100
150
800
 100
Output8
900
100
800
700
100
100
150
950
 50
Output8
1,100
100
1,000
850
150
100
150
1,100
0
1,300
100
1,200
1,000
200
100
150
1,250
+ 50
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Karl Case, Ray Fair
Equilibrium
Output9
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C H A P T E R 21: The Government and Fiscal Policy
The Government Spending Multiplier
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C H A P T E R 21: The Government and Fiscal Policy
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.
• A tax cut has no direct impact on
spending. The multiplier for a
change in taxes is smaller than the
multiplier for a change in government
spending.
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C H A P T E R 21: The Government and Fiscal Policy
The Tax Multiplier
 1 
 Y  (initial increase in aggregate expenditure)  

 MPS 
 1 
 MPC 
 Y  (   T  MPC )  
   T  

 MPS 
 MPS 
 MPC 
Tax multiplier   

 MPS 
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C H A P T E R 21: The Government and Fiscal Policy
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.
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C H A P T E R 21: The Government and Fiscal Policy
The Balanced-Budget Multiplier
Finding Equilibrium After a $200 Billion Balanced Budget Increase in G and T
(All Figures in Billions of Dollars; G and T Have Increased From 100 in Table 25.1 to 300 Here)
(1)
OUTPUT
(INCOME)
Y
(2)
(3)
NET
DISPOSABLE
TAXES
INCOME
T
Yd / Y  T
(4)
(5)
(6)
(7)
PLANNED
PLANNED
CONSUMPTION INVESTMENT GOVERNMENT AGGREGATE
SPENDING
SPENDING
PURCHASES EXPENDITURE
(C = 100 + .75 Yd)
I
G
C+I+G
(8)
(9)
UNPLANNED
INVENTORY
CHANGE
Y  (C + I + G)
ADJUSTMENT
TO
DISEQUILIBRIUM
500
300
200
250
100
300
650
 150
Output8
700
300
400
400
100
300
800
 100
Output8
900
300
600
550
100
300
950
 50
Output8
1,100
300
800
700
100
300
1,100
0
1,300
300
1,000
850
100
300
1,250
+ 50
Output9
1,500
300
1,200
1,000
100
300
1,400
+ 100
Output9
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Principles of Economics, 7/e
Karl Case, Ray Fair
Equilibrium
18 of 35
C H A P T E R 21: The Government and Fiscal Policy
Fiscal Policy Multipliers
Summary of Fiscal Policy Multipliers
POLICY STIMULUS
MULTIPLIER
Governmentspending
multiplier
Increase or decrease in the
level of government
purchases:
1
MPS
Tax multiplier
Increase or decrease in the
level of net taxes:
 MPC
MPS
Balancedbudget
multiplier
Simultaneous balanced-budget
increase or decrease in the
level of government purchases
and net taxes:
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1
FINAL IMPACT ON
EQUILIBRIUM Y
1
G
MPS
T 
 MPC
MPS
G
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C H A P T E R 21: The Government and Fiscal Policy
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 (-).
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C H A P T E R 21: The Government and Fiscal Policy
The Federal Budget
Federal Government Receipts and Expenditures, 2000 (Billions of Dollars)
AMOUNT
PERCENTAGE
OF TOTAL
Receipts
Personal taxes
Corporate taxes
Indirect business taxes
Contributions for social insurance
Total
1,010.1
193.2
111.0
720.6
2,034.9
49.6
9.5
5.5
35.4
100.0
Current Expenditures
Consumption
Transfer payments
Grants-in-aid to state and local governments
Net interest payments
Net subsidies of government enterprises
Total
Current Surplus (+) or deficit () (Receipts  Current Expenditures)
514.1
831.9
274.2
236.9
52.5
1,909.6
+ 125.3
26.9
43.6
14.4
12.4
2.7
100.0
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
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C H A P T E R 21: The Government and Fiscal Policy
The Federal Government Surplus (+) or
Deficit (-) as a Percentage of GDP, 1970 I2003 II
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C H A P T E R 21: The Government and Fiscal Policy
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 (nongovernment-owned) portion of the
federal debt.
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C H A P T E R 21: The Government and Fiscal Policy
The Federal Government Debt as a
Percentage of GDP, 1970 I2003 II
The percentage began to fall in the mid 1990s.
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C H A P T E R 21: The Government and Fiscal Policy
The Economy’s Influence
on 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.
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C H A P T E R 21: The Government and Fiscal Policy
The Economy’s Influence
on the Government Budget
• Fiscal drag 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.
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C H A P T E R 21: The Government and Fiscal Policy
The Economy’s Influence
on the Government Budget
• The full-employment budget
is what the federal budget
would be if the economy were
producing at a full-employment
level of output.
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C H A P T E R 21: The Government and Fiscal Policy
The Economy’s Influence
on 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.
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C H A P T E R 21: The Government and Fiscal Policy
Review Terms and Concepts
automatic stabilizers
fiscal drag
balanced-budget multiplier
fiscal policy
budget deficit
full-employment budget
cyclical deficit
government spending multiplier
discretionary fiscal policy
monetary policy
disposable, or after-tax,
income
net taxes
privately held federal debt
federal budget
structural deficit
federal debt
tax multiplier
federal surplus (+) or deficit (-)
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Karl Case, Ray Fair
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C H A P T E R 21: The Government and Fiscal Policy
Appendix A:
Deriving the Fiscal Policy Multipliers
The government spending and tax multipliers algebraically:
C  a  b(Y  T )
Y  C I  G
Y  a  b(Y  T )  I  G
Y  a  bY  bT  I  G
Y  bY  a  bT  I  G
Y (1 b)  a  bT  I  G
1
Y
(a  bT  I  G )
1 b
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C H A P T E R 21: The Government and Fiscal Policy
Appendix A:
Deriving the Fiscal Policy Multipliers
• The balanced-budget multiplier is found by
combining the effects of government
spending and taxes:
increase in spending:
G
- decrease in spending:
C  T (MPC )
= net increase in spending
G  T (MPC )
G  T
 1 
Y  G(MPS ) 
  G
 MPS 
© 2004 Prentice Hall Business Publishing
• 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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C H A P T E R 21: The Government and Fiscal Policy
Appendix B: The Case In Which
Tax Revenues Depend on Income
Y  C I  G
T  T0  tY
Yd  Y  T
T  200  1 3Y
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C H A P T E R 21: The Government and Fiscal Policy
Appendix B: The Case In Which
Tax Revenues Depend on Income
Yd  Y  T
T  200  1 3Y
Yd  Y  (200  1 3Y )
Yd  Y  200  1 3Y )
C  a  bYd
C  100  .75(Y  200 1 3Y )
Y  C  I G
I  100 G  100
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Y  900
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C H A P T E R 21: The Government and Fiscal Policy
Appendix B: The Case In Which
Tax Revenues Depend on Income
The Government Spending and Tax Multipliers Algebraically:
C  a  b(Y  T )
C  a  b(Y  T0  tY )
C  a  bY  bT0  btY
Y  C  I G
Y  a  bY  bT0  btY  I  G
1
Y
(a  bT0  I  G )
1  b  bt
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C H A P T E R 21: The Government and Fiscal Policy
Appendix B: The Case In Which
Tax Revenues Depend on Income
• The government spending and tax multipliers when taxes
are a function of income are derived as follows:
Y  C I  G
C  a  b(Y  T )
C  a  b(Y  T0  tY )
1
Y
(a  bT0  I  G )
1  b  bt
C  a  bY  bT0  btY
Y  a  bY  bT0  btY  I  G
Y  bY  btY  a  bT0  I  G
Y (1  b  bt )  a  bT0  I  G
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