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Government in the EconomyGovernment in the Economy
• Nothing arouses as much controversy as Nothing arouses as much controversy as the role of government in the economy.the role of government in the economy.
• Government can affect the macroeconomy Government can affect the macroeconomy through two policy channels: fiscal policy through two policy channels: fiscal policy and monetary policy.and monetary policy.
• Fiscal policyFiscal policy is the manipulation of is the manipulation of government spending and taxation.government spending and taxation.
• Monetary policyMonetary policy refers to the behavior of the refers to the behavior of the Federal Reserve regarding the nation’s money Federal Reserve regarding the nation’s money supply.supply.
Government in the EconomyGovernment in the Economy
• Tax rates are controlled by the Tax rates are controlled by the government, but tax revenue depends on government, but tax revenue depends on changes in household income and the size changes in household income and the size of corporate profits, which the government of corporate profits, which the government cannot control.cannot control.
• Discretionary fiscal policyDiscretionary fiscal policy refers to refers to changes in taxes or spending that are the changes in taxes or spending that are the result of deliberate changes in government result of deliberate changes in government policy.policy.
Net Taxes (Net Taxes (TT), and Disposable Income (), and Disposable Income (YYdd))
• Net taxesNet taxes are taxes paid by firms and are taxes paid by firms and households to the government minus households to the government minus transfer payments made to households by transfer payments made to households by the government.the government.
• DisposableDisposable, or , or after-taxafter-tax, , income (Yincome (Ydd))
equals total income minus taxes.equals total income minus taxes.
Adding Net Taxes (Adding Net Taxes (TT) and Government Purchases ) and Government Purchases ((GG) to the Circular Flow of Income) to the Circular Flow of Income
Adding Net Taxes (Adding Net Taxes (TT) and Government Purchases ) and Government Purchases ((GG) to the Circular Flow of Income) to the Circular Flow of Income
• When government enters the picture, the When government enters the picture, the aggregate income identity gets cut into aggregate income identity gets cut into three pieces:three pieces:
Y Y Td
Y C Sd
Y T C S Y C S T
• And aggregate expenditure (And aggregate expenditure (AEAE) equals:) equals:
• A government’s A government’s budget deficitbudget deficit is the is the difference between what it spends (difference between what it spends (GG) and ) and what it collects in taxes (what it collects in taxes (TT) in a given ) in a given period:period:
B udget def G Ticit
• If If GG exceeds exceeds TT, the government must , the government must borrow from the public to finance the deficit. borrow from the public to finance the deficit. It does so by selling Treasury bonds and It does so by selling Treasury bonds and bills. In this case, a part of household bills. In this case, a part of household saving (saving (SS) goes to the government.) goes to the government.
Adding Taxes to theAdding Taxes to theConsumption FunctionConsumption Function
• With taxes a part of the picture, the With taxes a part of the picture, the aggregate consumption function is a aggregate consumption function is a function of disposable, or after-tax, function of disposable, or after-tax, income.income.
Equilibrium Output: Equilibrium Output: YY = = CC + + II + + GG
Finding Equilibrium for Finding Equilibrium for I I = 100, = 100, GG = 100, and = 100, and T T = 100= 100(All Figures in Billions of Dollars)(All Figures in Billions of Dollars)
The Leakages/Injections ApproachThe Leakages/Injections Approach
• Taxes (Taxes (TT) are a leakage from the flow of ) are a leakage from the flow of income. Saving (income. Saving (SS) is also a leakage.) is also a leakage.
• In equilibrium, aggregate output (income) In equilibrium, aggregate output (income) ((YY) equals planned aggregate expenditure ) equals planned aggregate expenditure ((AEAE), and leakages (), and leakages (SS + + TT) must equal ) must equal planned injections (planned injections (II + + GG). Algebraically,). Algebraically,
The Government Spending MultiplierThe Government Spending Multiplier
• The government spending multiplier is the The government spending multiplier is the ratio of the change in the equilibrium level ratio of the change in the equilibrium level of output to a change in government of output to a change in government spending.spending.
The Government Spending MultiplierThe Government Spending Multiplier
Finding Equilibrium After a $50 Billion Government Spending IncreaseFinding Equilibrium After a $50 Billion Government Spending Increase(All Figures in Billions of Dollars; (All Figures in Billions of Dollars; GG Has Increased From 100 in Table 25.1 to 150 Here) Has Increased From 100 in Table 25.1 to 150 Here)
• A tax cut increases disposable income, A tax cut increases disposable income, which is likely to lead to added which is likely to lead to added consumption spending. Income will consumption spending. Income will increase by a multiple of the decrease in increase by a multiple of the decrease in taxes.taxes.
• However, a tax cut has no direct impact on However, a tax cut has no direct impact on spending. The tax multiplier for a change spending. The tax multiplier for a change in taxes is smaller than the multiplier for a in taxes is smaller than the multiplier for a change in government spending.change in government spending.
• However, a tax cut has no direct impact on However, a tax cut has no direct impact on spending. The tax multiplier for a change spending. The tax multiplier for a change in taxes is smaller than the multiplier for a in taxes is smaller than the multiplier for a change in government spending.change in government spending.
YM P S
( in itia l in c rease in ag g reg a te ex p en d itu re )
The Balanced-Budget MultiplierThe Balanced-Budget Multiplier
• The The balanced-budget multiplierbalanced-budget multiplier is is the ratio of change in the equilibrium the ratio of change in the equilibrium level of output to a change in level of output to a change in government spending where the government spending where the change in government spending is change in government spending is balanced by a change in taxes so as balanced by a change in taxes so as not to create any deficit.not to create any deficit.
The Balanced-Budget MultiplierThe Balanced-Budget Multiplier
Finding Equilibrium After a $200 Billion Balanced Budget Increase in Finding Equilibrium After a $200 Billion Balanced Budget Increase in GG and and TT(All Figures in Billions of Dollars; (All Figures in Billions of Dollars; GG and and TT Have Increased From 100 in Table 25.1 to 300 Here) Have Increased From 100 in Table 25.1 to 300 Here)
Simultaneous balanced-budgetSimultaneous balanced-budgetincrease or decrease in theincrease or decrease in thelevel of government purchaseslevel of government purchasesand net taxes: and net taxes:
Adding the International SectorAdding the International Sector
• We can think of imports (We can think of imports (IMIM) as a leakage ) as a leakage from the circular flow and exports (from the circular flow and exports (EXEX) as ) as an injection into the circular flow.an injection into the circular flow.
• With imports and exports, the equilibrium With imports and exports, the equilibrium condition for the economy is:condition for the economy is:
O pen-econo m y equ ilib rium : Y C I G X M ( )
• The quantity (The quantity (EXEX – – IMIM) is referred to as ) is referred to as net net exports.exports. Increases or decreases in net Increases or decreases in net exports can throw the economy out of exports can throw the economy out of equilibrium and cause national income to equilibrium and cause national income to change.change.
Federal Government Receipts and Expenditures, 2000 (Billions of Dollars)Federal Government Receipts and Expenditures, 2000 (Billions of Dollars)
AMOUNTAMOUNTPERCENTAGE PERCENTAGE
OF TOTALOF TOTAL
ReceiptsReceiptsPersonal taxesPersonal taxes 774.4774.4 44.944.9Corporate taxesCorporate taxes 211.9211.9 12.312.3Indirect business taxesIndirect business taxes 91.391.3 5.35.3Contributions for social insuranceContributions for social insurance 645.9645.9 37.537.5
ConsumptionConsumption 463.8463.8 26.526.5Transfer paymentsTransfer payments 795.5795.5 45.445.4Grants-in-aid to state and local governmentsGrants-in-aid to state and local governments 224.2224.2 12.812.8Net interest paymentsNet interest payments 230.3230.3 13.113.1Net subsidies of government enterprisesNet subsidies of government enterprises 38.438.4 2.22.2
TotalTotal 1,752.21,752.2 100.0100.0Current Surplus (+) or deficit (Current Surplus (+) or deficit () ) (Receipts (Receipts Current Expenditures) Current Expenditures) 28.828.8
Source:Source: U.S. Department of Commerce, Bureau of Economic Analysis. U.S. Department of Commerce, Bureau of Economic Analysis.
The Federal Government Surplus/Deficit as The Federal Government Surplus/Deficit as a Percentage of GDP, 1970 Ia Percentage of GDP, 1970 I2000 IV2000 IV
The Economy’s Influence on the The Economy’s Influence on the Government BudgetGovernment Budget
• Tax revenues depend on the state of Tax revenues depend on the state of the economy.the economy.
• Some government expenditures Some government expenditures depend on the state of the economy.depend on the state of the economy.
• Automatic stabilizersAutomatic stabilizers are revenue are revenue and expenditure items in the federal and expenditure items in the federal budget that automatically change budget that automatically change with the state of the economy in such with the state of the economy in such a way as to stabilize a way as to stabilize GDPGDP..
The Economy’s Influence on the The Economy’s Influence on the Government BudgetGovernment Budget
• Fiscal dragFiscal drag is the negative effect on is the negative effect on the economy that occurs when the economy that occurs when average tax rates increase because average tax rates increase because taxpayers have moved into higher taxpayers have moved into higher income brackets during an income brackets during an expansion.expansion.
The Economy’s Influence on the The Economy’s Influence on the Government BudgetGovernment Budget
• The The full-employment budgetfull-employment budget is a is a benchmark for evaluating fiscal benchmark for evaluating fiscal policy.policy.
• The The full-employment budgetfull-employment budget is what is what the federal budget would be if the the federal budget would be if the economy were producing at a full-economy were producing at a full-employment level of output.employment level of output.
The Economy’s Influence on the The Economy’s Influence on the Government BudgetGovernment Budget
• The The cyclical deficitcyclical deficit is the is the deficit that occurs because of deficit that occurs because of a downturn in the business a downturn in the business cycle.cycle.
• The The structural deficitstructural deficit is the is the deficit that remains at full deficit that remains at full employment.employment.
Appendix A:Appendix A:The government spending and tax multipliersThe government spending and tax multipliers
• The government spending and tax multipliers when The government spending and tax multipliers when taxes are a function of income are derived as follows:taxes are a function of income are derived as follows:
Appendix A: The Balanced-Budget MultiplierAppendix A: The Balanced-Budget Multiplier
• If we combine the effects of the government If we combine the effects of the government spending multiplier and the tax multiplier, we spending multiplier and the tax multiplier, we obtain:obtain:
Y
G M P S=
1and
Y
T
M P C
M P S
Taxmultiplier
Multiplier ofgovernmentspending
11
M P S
M P C
M P S
M P S
M P S
• In words, a simultaneous increase in government In words, a simultaneous increase in government spending by $1 and lump-sum taxes by $1 will spending by $1 and lump-sum taxes by $1 will increase equilibrium income by $1.increase equilibrium income by $1.
Appendix B:Appendix B:The government spending and tax multipliersThe government spending and tax multipliers
• The government spending and tax multipliers are The government spending and tax multipliers are derived algebraically as follows:derived algebraically as follows: