Chapter 9
The Government and Fiscal Policy
CHAPTER 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 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
Appendix A: Deriving the Fiscal Policy Multipliers
Appendix B: The Case in Which Tax Revenues
Depend on Income

THE GOVERNMENT AND FISCAL POLICY fiscal policy The government’s spending and taxing policies.
monetary policy The behavior of the Federal Reserve concerning the nation’s money supply.

Government in the Economy discretionary fiscal policy Changes in taxes or spending that are the result of deliberate changes in government policy.
Government Purchases ( G ), Net Taxes ( T ), and Disposable Income ( Y d
) 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
Total income minus net taxes: Y − T . d
) disposable income ≡ total income − net taxes
Y d
≡ Y − T

 FIGURE 9.1
Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income: A little more complicated

The disposable income ( Y d
) of households must end up as either consumption ( C ) or saving ( S ).
Thus, Y d

C

S
Because disposable income is Y d another identity:
≡ Y − T , we can write
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

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
Which can also be written as the difference between what the government collects in taxes and what it spends in a given period: T − G : budget deficit ≡ T − G

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 or
C = a + b ( Y − T )
Our consumption function now has consumption depending on disposable income instead of before-tax income.

I
The government can affect investment behavior through its tax treatment of depreciation and other tax policies.
Planned investment depends on the interest rate.
For purposes of this chapter, as in chapter 8, we assume the interest rate and planned investment
( I ) are fixed..
- I is assumed to be autonomous.

We assume G is fixed, G is autonomous.
We initially assume T is fixed, T is autonomous.

The Determination of Equilibrium Output (Income)
Y = C + I + G
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)
Output
(Income)
Y
Net
Taxes
T
Disposable
Income
Y d
≡Y −T
Consumption
Spending
C = 100 + .75 Y d
Saving
Y d
S
– C
Planned
Investment
Spending
I
Government
Purchases
G
Planned
Aggregate
Expenditure
C + I + G
Unplanned
Inventory
Change
Y − (C + I + G)
Adjustment to Disequilibrium
300
500
100
100
700 100
900 100
1,100 100
1,300 100
1,500 100
200
400
600
800
1,000
1,200
1,400
250
400
550
700
850
1,000
1,150
− 50
0
50
100
150
200
250
100
100
100
100
100
100
100
100
100
100
100
100
100
100
450
600
750
900
1,050
1,200
1,350
− 150
− 100
− 50
0
+ 50
+ 100
+ 150
Output
↑
Output
↑
Output
↑
Equilibrium
Output
↓
Output
↓
Output ↓


FIGURE 9.2
Finding
Equilibrium Output/Income
Graphically
Because G and I are both fixed at 100, the aggregate expenditure function is the consumption function displaced upward by
I + G = 200.
Equilibrium occurs at
Y = C + I + G = 900.

The Determination of Equilibrium Output (Income)
The Math
Equilibrium condition: Y = C + I + G
The sectors:
C = 100 + .75(Y – T)
I = 100
T = 100
G = 100
Substitute the sector information into equilibrium condition:
Y = 100+.75(Y – 100) + 100 + 100
.25Y = 100 – 75 + 100 + 100
.25Y = 225
Y = 225/.25
Y = 900

The Saving/Investment Approach to Equilibrium saving/investment approach to equilibrium:
S + T = I + G
To derive this, we know that in equilibrium, aggregate output
(income) ( Y ) equals planned aggregate expenditure ( AE ).
By definition: AE = C + I + G and by definition Y = C + S + T.
Therefore, at equilibrium:
Y = AE
C + S + T = C + I + G
Subtracting C from both sides leaves:
S + T = I + G

At this point, we are assuming that the government controls G and T . In this section, we will examine three multipliers:
Government spending multiplier
Tax multiplier
Balanced-budget multiplier

Fiscal Policy at Work: Multiplier Effects government spending multiplier The ratio of the change in the equilibrium level of output to a change in government spending =

Y

G government spending multiplier

1
1

MPC

1
MPS
Same as the investment spending multiplier

TABLE 9.2 Finding Equilibrium after a Government Spending Increase of 50 (G Has Increased from 100 in Table 9.1 to 150 Here) MPC =
0.75
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
Output
(Income)
Y
Net
Taxes
T
300 100
Disposable
Income
Y d
≡Y −T
200
Consumption
Spending
C = 100 + .75 Y d
250
500 100 400 400
Saving
Y d
S
– C

50
0
Planned
Investment
Spending
I
100
Government
Purchases
G
150
Planned
Aggregate
Expenditure
C + I + G
Unplanned
Inventory
Change
Y − (C + I + G)
500

200
Adjustment to
Disequilibrium
Output
↑
100 150 650

150 Output ↑
700
900
100
100
600
800
550
700
50
100
100
100
150
150
800
950

100

50
Output
Output
↑
↑
1,100
1,300
100
100
1,000
1,200
850
1,000
150
200
100
100
150
150
1,100
1,250
0
+ 50
Equilibrium
Output ↓


FIGURE 9.3
The Government Spending Multiplier
MPC = 0.75
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.

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS
THE TAX MULTIPLIER
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 =

Y

T

FISCAL POLICY AT WORK: MULTIPLIER EFFECTS tax multiplier


MPC
1

MPC

MPC
MPS

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

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)
Output
(Income)
Y
500
700
Net
Taxes
T
300
Disposable
Y
Income d
≡Y − T
200
Consumption
Spending
C = 100 + .75 Y d
250
Planned
Investment
Spending
I
100
Government
Purchases
G
300
Planned
Aggregate
Expenditure
C + I + G
650
Unplanned
Inventory
Change
Y − (C + I + G)
−150
300 400 400 100 300 800 −100
Adjustment to
Disequilibrium
Output ↑
Output ↑
900 300 600 550 100 300 950 −50 Output ↑
1,100
1,300
1,500
300
300
300
800
1,000
1,200
700
850
1,000
100
100
100
300
300
300
1,100
1,250
1,400
0
+ 50
+ 100
Equilibrium
Output
↓
Output ↓

TABLE 9.4 Summary of Fiscal Policy Multipliers
Government spending multiplier
Policy Stimulus
Increase or decrease in the level of government purchases:
∆
G
Multiplier
1
MPS
Final Impact on
Equilibrium Y
1
MPS
Tax multiplier Increase or decrease in the level of net taxes: ∆ T
Balancedbudget multiplier
Simultaneous balanced-budget increase or decrease in the level of government purchases and net taxes: ∆ G = ∆ T

MPC
MPS
1

MPC
MPS

G

A Warning
Although we have added government, the story told about the multiplier is still incomplete and oversimplified.
We have been treating net taxes ( T ) as a lump-sum, fixed amount, whereas in practice, taxes depend on income.
Appendix B to this chapter shows that the size of the multiplier is reduced when we make the more realistic assumption that taxes depend on income.
We continue to add more realism and difficulty to our analysis in the chapters that follow.

Receipts and Expenditures of the Federal
Government.
Also referred to as Revenues and Outlays of the Federal Government federal budget surplus (+) or deficit ( −):
Federal government receipts minus expenditures.

The Budget in 2012
TABLE 9.5 Federal Government Receipts and Expenditures, 2012 (Billions of Dollars)
Amount Percentage of Total
Current receipts
Personal income taxes
Excise taxes and customs duties
Corporate income taxes
Taxes from the rest of the world
Contributions for social insurance
Interest receipts and rents and royalties
Current transfer receipts from business and persons
Current surplus of government enterprises
Total
Current expenditures
Consumption expenditures
Transfer payments to persons
Transfer payments to the rest of the world
Grants-in-aid to state and local governments
Interest payments
Subsidies
Total
Net federal government saving: surplus (+) or deficit (−)
(Total current receipts − Total current expenditures)
1,137.8
116.1
373.7
17.3
934.8
53.4
59.2
− 17.8
2,674.5
1,059.6
1,773.2
76.4
468.0
318.5
60.4
3,756.1
− 1,081.6
42.5
4.3
14.0
0.6
35.0
2.0
2.2
− 0.7
100.0
28.2
47.2
2.0
12.5
8.5
1.6
100.0
federal surplus (+) or deficit ( −) Federal government receipts minus expenditures.

The Budget in 2015 – selected items
TABLE 9.5 Federal Government Receipts and Expenditures, 2012 (Billions of Dollars)
Amount Percentage of Total
Current receipts
Personal income taxes
Excise taxes and customs duties
Corporate income taxes
Taxes from the rest of the world
Contributions for social insurance
Interest receipts and rents and royalties
Current transfer receipts from business and persons
Other
Total
Current expenditures
Mandatory
Discretionary
1,541
344
1,065
299
3,249
2,299
1,165
47.4
10.6
32.7
9.2
100.0
70.0
24.0
Interest payments
Subsidies
Total
Net federal government saving: surplus (+) or deficit (−)
(Total current receipts − Total current expenditures)
223
3,687
− 438
6.0
100.0
federal surplus (+) or deficit ( −) Federal government receipts minus expenditures.

Federal Outlays and Revenue, 1965 –2025:
Expressed as percent of GDP
27

Budget Surplus or Deficit:1959 –2015, Expressed as percent of GDP
Deficits increase during recessions and decrease during expansions
28

The Economy’s Influence on the Government
Budget – 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.
• 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.

– budget deficit automatically increases because transfers payments rise and tax revenue falls
(or the budget surplus decreases)
– budget deficit automatically decreases because transfers decrease and tax revenue rises
(or the budget surplus increases)
30

– increase the public’s bond holdings
– increase the national debt
– decrease the public’s bond holdings
– decrease the national debt
– national debt as a percentage of GDP
31

The U.S. Debt Ratio
Obama
Clinton
Bush
Reagan
Debt as a percentage of GDP soared during World War II, then fell steadily for several decades. It rose during the 1980s, fell in the 1990s, and then surged from 2009 –2011 due to recession and fiscal stimulus policies.

– In Dec 2015, it was approaching $18.9 trillion
– Amount the government owed to the public was $13.6 trillion, privately held.
• This has a macroeconomic impact
– Amount that one government agency owed to another was about $5.3 trillion)
• No macroeconomic impact at all
33

http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt
34

Full-Employment Budget full-employment budget What the federal budget would be if the economy were producing at the 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.

R E V I E W T E R M S A N D C O N C E P T S automatic destabilizers automatic stabilizers balanced-budget multiplier budget deficit cyclical deficit discretionary fiscal policy disposable, or after-tax, income ( Y d
) federal budget federal debt federal surplus (+) or deficit (−) fiscal drag fiscal policy full-employment budget government spending multiplier monetary policy net taxes ( T ) privately held federal debt structural deficit tax multiplier
Disposable income Y d
≡ Y − T
AE ≡ C + I + G
Government budget deficit ≡ G − T
Equilibrium in an economy with a government: Y = C + I + G
Saving/investment approach to equilibrium in an economy with a government: S + T = I + G
Government spending multiplier

1
MPS

1

1
MPC
MPC
7. Tax multiplier ≡
MPS
8. Balanced-budget multiplier ≡ 1

CHAPTER 9 APPENDIX A
Deriving the Fiscal Policy Multipliers
The Government Spending and Tax Multipliers
We can derive the multiplier algebraically using our hypothetical consumption function:
C a (

T )
The equilibrium condition is
Y

C I G
By substituting for C , we get
Y a (

T ) I G
Y a bY
 bT I G
This equation can be rearranged to yield
Y
 bY a I G
 bT
Y ( 1
 b )
  
G
 bT
Now solve for Y by dividing through by (1 − b ):
Y


1
1
 b
 ( a

I

G
 bT )

Δ Y =
1
1−𝑚𝑝𝑐 x Δ
I Investment Spending Multiplier
Δ Y =
1
1−𝑚𝑝𝑐 x Δ G Government Spending Multiplier
Δ Y =
−𝑚𝑝𝑐
1−𝑚𝑝𝑐 x Δ
T Lump-sum Tax Multiplier
Δ Y =
−𝑚𝑝𝑐
1−𝑚𝑝𝑐 x Δ a Autonomous Spending Multiplier

CHAPTER 9 APPENDIX B
The Case in Which Tax Revenues Depend on Income

FIGURE 9B.1
The Tax Function
This graph shows net taxes
(taxes minus transfer payments) as a function of aggregate income.
Y d

Y

T
Y d

Y

(

200

1 / 3 Y )
Y d

Y

200

1 / 3 Y
C

100

.
75 Y d
C

100

.
75 ( Y

200

1 / 3 Y )

Y

C

I

G
Y
 
Y
 
Y
C
 
I G
Y

100

.
75 Y

150

25 Y

100

100
.
Y
5

450

.
5 Y
Y

450

FIGURE 9B.2
Different Tax
Systems
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.

The Government Spending and Tax Multipliers Algebraically
C a (

T )
C
 
(
 
0 tY )
C
  bY
 bT
0
 btY
We know that Y = C + I + G . Through substitution we get
Y
  bY
 bT
0
 btY
 
G
C
Solving for Y :
Y

1
1 b bt
( a I G
 bT
0
)

This means that a $1 increase in G or I (holding a and T
0 constant) will increase the equilibrium level of Y by
1
1 b bt
1
=
1−𝑚𝑝𝑐+(𝑚𝑝𝑐 𝑥 𝑡)
Holding a , I , and G constant, a fixed or lump-sum tax cut (a cut in T
0
) will increase the equilibrium level of income by
 b
1
 b
 bt
−𝑚𝑝𝑐
=
1−𝑚𝑝𝑐+(𝑚𝑝𝑐 𝑥 𝑡)