The Government and

Fiscal Policy 9
CHAPTER OUTLINE
Government in the Economy
Government Purchases (G), Net Taxes (T), and Disposable
Income (Yd)
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
LookingAhead
Appendix A: Deriving the Fiscal PolicyMultipliers
Appendix B: The Case in Which TaxRevenues
Depend on Income
© 2014 Pearson Education,Inc. 1 of 40
 Government in the economy
 The government can affect the economy through two
policies:
1- Monetary Policy: is the decision of the central bank to
change the total money supply.

In time of high unemployment (recession or slump) the

central bank adopts an expansionary monetary policy (MS )

In time of inflation (boom) the central bank adopts a

contractionary monetary policy (MS ).
© 2014 Pearson Education,Inc. 2 of 40
Government in the economy
2. Fiscal Policy: The government can affect the economy through
two policies;

 The government’s spending

Gov. Expenditure (G): includes all government purchases of goods &
services.

 Taxing policies.
Net Taxes (T): Taxes paid by firms and households to the
government minus transfer payments made to households by the
government(such as unemployment compensation, Social
Security benefits, welfare payments, and veterans’ benefits)

Net Taxes (T) = taxes – government transfer payments.

Government in the economy
 FIGURE 9.1 Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of
Income

© 2014 Pearson Education,Inc. 5 of 40

 Government Purchases (G ), Net Taxes (T ), and Disposable
Income (Yd)
Disposable, or after-tax, income (Yd) Total income minus net taxes: Y − T.

The disposable income (Yd) of households must end up as either

consumption (C) or saving (S). Thus,
Yd C  S

Because disposable income is aggregate income (Y) minus net taxes (T), we
can write another identity:
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

© 2014 Pearson Education,Inc. 6 of 40

The Determination of Equilibrium Output (Income) in a closed
Economy with Government

Under a closed economy with government, the equilibrium level of

output (GDP or income) can be determined using two approaches:

(1) Aggregate approach:

Output (Supply) = Planned aggregate expenditure ( Demand )

(2) Saving- Investment approach:

 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 + bYd

or

C = a + b (Y − T )

Our consumption function now has consumption

depending on disposable income instead of before-tax
income.

© 2014 Pearson Education,Inc. 8 of 40

 S= -a + (1-b)Yd
Example S= -125 + 0.25Y

AE= G+I+C

100 200 250 -50 100 100 400 -150

100 400 400 0 100 100 600 -100
100 600 550 50 100 100 750 -50
100 800 700 100 100 100 900 0
100 1000 850 150 100 100 1050 50
100 1200 1000 200 100 100 1200 100
100 1400 1150 250 100 100 1350 150
Equilibrium : Unplanned inventory
change = 0

Breakeven point : Saving = 0

 The Determination of Equilibrium Output (Income)

Y= C+ I + G

TABLE 9.1 Finding Equilibrium for I = 100, G = 100, and T = 100

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
Planned Planned Unplanned
Output Net Disposable Consumption Saving Investment Government Aggregate Inventory Adjustment
(Income) Taxes Income Spending S Spending Purchases Expenditure Change to Disequi-
Y T Yd ≡Y −T C = 100 + .75 Yd Yd – C I G C + I + G Y − (C + I + G) librium

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 Equilibrium
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 ↓

© 2014 Pearson Education,Inc. 10 of 40

 It does not consider T(tax) because it aggregate

FIGURE 9.2 Finding

Equilibrium Output/Income
Graphically

Because G and I are

both fixed at 100, the
aggregate expenditure
function is the new
consumption function
displaced upward by
I + G = 200.
Equilibrium occurs at
Y = C + I + G = 900.

© 2014 Pearson Education,Inc. 11 of 40