Principles of Economics

Twelfth Edition

Chapter 24
The Government
and Fiscal Policy

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The Government and Fiscal Policy

In macroeconomics, the policy instruments are fiscal policy and monetary

policy.
fiscal policy The government’s spending and taxing policies.
monetary policy The behavior of the Central Bank concerning the nation’s
money supply.

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Government in the Economy

Taxes and government spending often go up or down in response to changes in

the economy.

discretionary fiscal policy Changes in taxes or spending that are the result of
deliberate changes in government policy.

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Adding Net Taxes (T) and Government Purchases (G) to
the Circular Flow of Income

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Government Purchases, Net Taxes, and Disposable Income

net taxes (T) Taxes paid by firms and households to the government minus
transfer payments made to households and subsidies to firms by the
government.

disposable, or after-tax, income (Yd) Total income minus net taxes:

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Government Purchases, Net Taxes, and Disposable Income

budget balance The difference between what a government collects in taxes and
what it spends in a given period:

• balanced budget when

• budget surplus when

• budget deficit when

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Government Purchases, Net Taxes, and Disposable Income

Adding Taxes to the Consumption Function

Modify our aggregate consumption function to incorporate disposable income:

• The consumption function now has consumption depending on disposable

income instead of before-tax income.

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Government Purchases, Net Taxes, and Disposable Income

Planned Investment

The government can affect investment behavior through its tax treatment of
depreciation and other tax policies.

Planned investment depends on the interest rate.

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The Determination of Equilibrium Output (Income)

Equilibrium occurs when planned aggregate expenditure (AE) is equal to

aggregate output (Y).

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The Determination of Equilibrium Output

Planned aggregate expenditures (AE) have three components:

 Aggregate consumption (C)

 Planned investments (I)
 Government expenditures (G)

• So, equilibrium is:

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The Determination of Equilibrium Output

The Saving/Investment (Leakages/Injections) Approach to Equilibrium

Uses of disposable income:

At equilibrium:

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Finding Equilibrium

U. Adjustment
Y T Yd C= S= I G AE= Inv.
100 + 0.75 Yd Yd – C C+I+G Change
=Y − AE

300 100 200 250 −50 100 100 450 −150 Output ↑

500 100 400 400 0 100 100 600 −100 Output ↑

700 100 600 550 50 100 100 750 −50 Output ↑

900 100 800 700 100 100 100 900 0 Equi.

1,100 100 1,000 850 150 100 100 1,050 +50 Output ↓

1,300 100 1,200 1,000 200 100 100 1,200 +100 Output ↓

1,500 100 1,400 1,150 250 100 100 1,350 +150 Output ↓

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Equilibrium occurs at Y = C + I + G = 900.
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Fiscal Policy at Work: Multiplier Effects

We are assuming that the government controls G and T.

We now review three additional multipliers:

 Government spending multiplier

 Tax multiplier
 Balanced-budget multiplier

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The Multiplier Equations

At the equilibrium point: then

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The Government Spending Multiplier

government spending multiplier The ratio of the change in the equilibrium level of
output to a change in government spending.

∗ ∗
∗

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Finding Equilibrium after a Government Spending Increase by 50

Y T Yd C= S= I G AE= U. Inv. Adjustment

100 + 0.75 Yd Yd – C C+I+G Change

Output ↑
300 100 200 250 −50 100 150 500 −200

Output ↑
500 100 400 400 0 100 150 650 −150

Output ↑
700 100 600 550 50 100 150 800 −100

Output ↑
900 100 800 700 100 100 150 950 −50

Equi.
1,100 100 1,000 850 150 100 150 1,100 0

Output ↓
1,300 100 1,200 1,000 200 100 150 1,250 50

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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.

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The Tax Multiplier

tax multiplier The ratio of change in the equilibrium level of output to a

change in taxes.

∗ ∗
∗

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The Balanced-Budget Multiplier

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.

∗ ∗

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 The Balanced-Budget Multiplier

The balanced-budget multiplier is equal to 1: The change in Y resulting from the

change in G and the equal change in T is exactly the same size as the given
change in G or T.

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Finding Equilibrium after a Balanced-Budget Increase in G and T of 200 Each

Y T Yd C= I G AE= U. Inv. Adjustment

100 + .75 Yd C+I+G Change

Output ↑
500 300 200 250 100 300 650 −150

Output ↑
700 300 400 400 100 300 800 −100

Output ↑
900 300 600 550 100 300 950 -50

Equi.
1,100 300 800 700 100 300 1,100 0

Output ↓
1,300 300 1,000 850 100 300 1,250 +50

Output ↓
1,500 300 1,200 1,000 100 300 1,400 +100

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 Summary of Fiscal Policy Multipliers

Policy Stimulus Multiplier Final Impact on

Equilibrium Y
Government Increase or decrease in the
spending level of government
multiplier purchases: ∆G

Tax multiplier Increase or decrease in the

level of net taxes: ∆T

Balanced- Simultaneous balanced-budget 1

budget increase or decrease in the
multiplier level of government purchases
and net taxes: ∆G=∆T

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Fiscal Policy at Work: Multiplier Effects

 Government spending multiplier:

 Tax multiplier:

Two instruments of an expansionary fiscal policy (to increase aggregate output):

G↑ or T↓

Two instruments of a contractionary fiscal policy (to decrease aggregate output):

G↓ or T↑

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Multipliers

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.

The size of the multiplier is reduced when we make the more realistic
assumption that taxes depend on income.

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The Economy’s Influence on the Government Budget

Full-Employment Budget

full-employment budget What the 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.

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Ex: Suppose an economy with G=150, T=200, I=100 and C=150+0.75Yd.
Calculate the equilibrium level of Y, C and S. If taxes are reduced by 20,
recalculate the equilibrium level of Y using the tax multiplier.

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Ex: In the given economy, autonomous consumption expenditure is $100 billion
and the MPC is 0.9. Investment is $460 billion, government purchases of goods and
services are $400 billion, and net taxes are constant at $400 billion.

a. What is the consumption function?

b. What is the equation of the planned aggregate expenditures function?
c. Calculate the level of equilibrium expenditure.
d. If investment falls to $360 billion, what is the change in equilibrium
expenditure and what is the size of multiplier?

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Ex: The given economy has no imports or exports and no taxes. The figure shows
the components of AE on this economy. For this economy, calculate

a. the value of autonomous expenditure

b. the value of MPC (billion $)

c. AE when real GDP is $6 bln, what will

happen to inventories
d. if real GDP is $5 bln what will happen to
inventories
e. the multipliers

(billion $)

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Ex: Assume that in 2008, for the Republic of Nurd, Y=$200; C=160; S=40; I=30;
G=T=$0. Assume that households consume 80 percent of their income, they save
20 percent of their income. That is, C=0.8Yd ; S=0.2Yd.

a. Is the economy of Nurd in equilibrium? What is Nurd’s equilibrium level of

income? What is likely to happen in the coming months if the government takes
no action?
b. If $200 is the “full-employment” level of Y, what fiscal policy might the
government follow if its goal is full employment?
c. Suppose Y=200; C=160; S=40 and I=40. Is Nurd’s economy in equilibrium?
d. Starting with the situation in part d, suppose the government starts spending
30 each year with no taxation and continues to spend $30 every period. If I
remains constant, what will happen to the equilibrium level of Nurd’s domestic
product (Y)? What will the new levels of C and S be? (I=40; C=0.8Yd ; S=0.2Yd)

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e. Starting with the situation in part d, suppose the government starts taxing the
population $30 each year without spending anything and continues to tax that
rate every period. If I remains constant, what will happen to the equilibrium level
of Nurd’s domestic product (Y)? What will the new levels of C and S be? (I=40;
C=0.8Yd ; S=0.2Yd)

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Study Questions

Q1: Assume that consumption function for a closed economy is C=50+0.8Y, planned
investments are equal to TL 30, and government expenditures are equal to TL 10.
Calculate the equilibrium level of income? What happens to equilibrium Y if I
changes to TL 10? What is the value of investment multiplier? What happens to
equilibrium Y if G changes to TL 20? What is the value of government spending
multiplier?

Q2: For the economy of Yuk, the following data are given. Assume that consumers
spend 75 percent of their disposable income and save 25 percent.
a. Predict the events of the next few months (by using the data given, make a
forecast).
b. At what level of Y would the economy of Yuk settle?
c. Some local conservatives blame Yuk’s problems on the size of the government
sector. They suggest cutting government purchases by 25 billion. What effect would
such cuts have on the economy?

Real output/income 1000 billion

Government purchases 200 billion
Total net taxes 200 billion
Planned investment spending 100 billion

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REVIEW TERMS AND CONCEPTS

balanced-budget multiplier government spending multiplier

budget deficit monetary policy
cyclical deficit net taxes (T)
discretionary fiscal policy structural deficit
disposable, or after-tax, income (Yd) tax multiplier
budget surplus (+) or deficit (−)
fiscal policy
full-employment budget

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