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TOPIC 6
THE GOVERNMENT AND FISCAL
POLICY
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Government in the Economy
• Government can affect the macro economy 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.
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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.
Y  YT
d
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:
Yd = Y – T
Yd = C + S
Y–T = C+S
Y=C+S+T
• And aggregate expenditure (AE) equals:
AE = C + I + G
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Adding Taxes to the
Consumption Function
•
•
•
•
C = a + bYd
Yd = Y – T
C =a +b(Y–T)
The aggregate consumption function is now a
function of disposable, or after-tax, income.
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Equilibrium Output: Y = C + I + G
C = 100 + 0.75 Yd
C = 100 + 0.75 ( Y – T )
Finding Equilibrium for I = 100, G = 100, and T = 100
(All Figures in Billions of Dollars)
(1)
OUTPUT
(INCOME)
Y
(2)
(3)
(4)
(5)
(6)
PLANNED
NET DISPOSABLE CONSUMPTION SAVING INVESTMENT
TAXES
INCOME
SPENDING
S
SPENDING
T
Yd = Y  T (C = 100 + .75 Yd) (Yd – C)
I
(7)
GOVERNMENT
PURCHASES
G
(8)
PLANNED
AGGREGATE
EXPENDITURE
C+I+G
(9)
(10)
UNPLANNED
INVENTORY
CHANGE
ADJUSTMENT
Y  (C + I
TO
+ G)
DISEQUILIBRIUM
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
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
Equilibrium
Finding Equilibrium
Output/Income Graphically
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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,
AE = C + I + G
Y = C+S+T
C+S+T= C+I+G
S+T=I+G
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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.
1
Government spending multiplier =
MPS
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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.
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The Tax Multiplier
ΔY = (initial increase in aggregate expenditur e) X (
1
)
MPS
1
MPC
ΔY = (- ΔT x MPC) x (
) = - ΔT x (
)
MPS
MPS
MPC
Tax multiplier = - (
)
MPS
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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.