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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. Government in the Economy.
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The Governmentand 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
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.
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.
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.
Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income
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: • And aggregate expenditure (AE) equals:
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: • 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.
Adding Taxes to theConsumption Function • The aggregate consumption function is now a function of disposable, or after-tax, income.
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,
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.
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.
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.
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 (-).
The Federal Government Surplus (+) or Deficit (-) as a Percentage of GDP, 1970 I-2003 II
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 (non-government-owned) portion of the federal debt.
The Federal Government Debt as a Percentage of GDP, 1970 I-2003 II The percentage began to fall in the mid 1990s.
The Economy’s Influenceon 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.
The Economy’s Influenceon 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.
The Economy’s Influenceon 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.
The Economy’s Influenceon 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.
automatic stabilizers balanced-budget multiplier budget deficit cyclical deficit discretionary fiscal policy disposable, or after-tax, income federal budget federal debt federal surplus (+) or deficit (-) fiscal drag fiscal policy full-employment budget government spending multiplier monetary policy net taxes privately held federal debt structural deficit tax multiplier Review Terms and Concepts
Appendix A:Deriving the Fiscal Policy Multipliers The government spending and tax multipliers algebraically:
increase in spending: - decrease in spending: = net increase in spending Appendix A:Deriving the Fiscal Policy Multipliers • The balanced-budget multiplier is found by combining the effects of government spending and taxes: • The balanced-budget multiplier equals one. An increase in G and T by one dollar each causes a one-dollar increase in Y.
Appendix B: The Case In WhichTax Revenues Depend on Income The Government Spending and Tax Multipliers Algebraically:
Appendix B: The Case In WhichTax Revenues Depend on Income • The government spending and tax multipliers when taxes are a function of income are derived as follows:
