1. G, T, and the Multiplier

2. G, T, and the Multiplier fiscal policy The government’s spending and taxing policies. monetary policy The behavior of the Federal Reserve concerning the nation’s money supply.

3. Government in the Economy discretionary fiscal policy Changes in taxes or spending that are the result of deliberate changes in government policy. Government Purchases (G), Net Taxes (T), and Disposable Income (Yd) net taxes (T) Taxes paid by firms and households to the government minus transfer payments made to households by the government. disposable, or after-tax, income (Yd) Total income minus net taxes: Y − T. disposable income ≡ total income − net taxes Yd ≡ Y − T

4. Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Yd) The disposable income (Yd) of households must end up as either consumption (C) or saving (S). Thus, Because disposable income is aggregate income (Y) minus net taxes (T), we can write another identity: By adding T to both sides: 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). Y C Sd   Y T C S   Y C S T   GICAE 

5. Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Yd) 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.

6. Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Yd) Planned Investment The government can affect investment behaviour through its tax treatment of depreciation and other tax policies.

7. Government in the Economy The Determination of Equilibrium Output (Income) Y = C + I + G Finding Equilibrium for I = 100, G = 100, and T = 100 (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) Output (Income) Y Net Taxes T Disposable Income Yd ≡Y  T Consumption Spending C = 100 + .75 Yd Saving S Yd – C Planned Investment Spending I Government Purchases G Planned Aggregate Expenditure C + I + G Unplanned Inventory Change Y  (C + I + G) Adjustment to Disequi- 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 ↓

8. Government in the Economy The Determination of Equilibrium Output (Income) 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.

9. Government in the Economy The Determination of Equilibrium Output (Income) The Saving/Investment Approach to Equilibrium The government can affect investment behaviour through its tax treatment of depreciation and other tax policies. To derive this, we know that in equilibrium, aggregate output (income) (Y) equals planned aggregate expenditure (AE). By definition, AE equals C + I + G, and by definition, Y equals C + S + T. Therefore, at equilibrium: C + S + T = C + I + G Subtracting C from both sides leaves: S + T = I + G saving/investment approach to equilibrium: S + T = I + G

10. Fiscal Policy at Work: Multiplier Effects At this point, we are assuming that the government controls G and T. In this section, we will review three multipliers: • Government spending multiplier • Tax multiplier • Balanced-budget multiplier

11. Fiscal Policy at Work: Multiplier Effects The Government Spending Multiplier 1 government spending multiplier MPS  government spending multiplier The ratio of the change in the equilibrium level of output to a change in government spending.

12. Fiscal Policy at Work: Multiplier Effects The Government Spending Multiplier Finding Equilibrium after a Government Spending Increase of 50 (G Has Increased from 100 in Table 9.1 to 150 Here) (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) Output (Income) Y Net Taxes T Disposable Income Yd ≡Y  T Consumption Spending C = 100 + .75 Yd Saving S Yd – C Planned Investment Spending I Government Purchases G Planned Aggregate Expenditure C + I + G Unplanned Inventory Change Y  (C + I + G) Adjustment to Disequilibrium 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 Output ↑ 1,100 100 1,000 850 150 100 150 1,100 0 Equilibrium 1,300 100 1,200 1,000 200 100 150 1,250 + 50 Output ↓

13. Fiscal Policy at Work: Multiplier Effects The Government Spending Multiplier The Government Spending Multiplier 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.

14. Fiscal Policy at Work: Multiplier Effects The Tax Multiplier tax multiplier The ratio of change in the equilibrium level of output to a change in taxes. Because the initial change in aggregate expenditure caused by a tax change of ∆T is (−∆T × MPC), we can solve for the tax multiplier by substitution: Y MPS        (initial increase in aggregate expenditure) 1 1 ( ) MPC Y T MPC T MPS MPS                      Because a tax cut will cause an increase in consumption expenditures and output and a tax increase will cause a reduction in consumption expenditures and output, the tax multiplier is a negative multiplier:  tax multiplier MPC MPS  

15. Fiscal Policy at Work: Multiplier Effects 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. The balanced-budget multiplier is equal to 1: The change in Y resulting from the change in G and the equal change in T are exactly the same size as the initial change in G or T. 1balanced-budget multiplier

16. Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier Finding Equilibrium after a Balanced-Budget Increase in G and T of 200 Each (Both G and T Have Increased from 100 in Table 9.1 to 300 Here) (1) (2) (3) (4) (5) (6) (7) (8) (9) Output (Income) Y Net Taxes T Disposable Income Yd ≡Y  T Consumption Spending C = 100 + .75 Yd Planned Investment Spending I Government Purchases G Planned Aggregate Expenditure C + I + G Unplanned Inventory Change Y  (C + I + G) Adjustment to Disequilibrium 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 Output ↑ 1,100 300 800 700 100 300 1,100 0 Equilibrium 1,300 300 1,000 850 100 300 1,250 + 50 Output ↓ 1,500 300 1,200 1,000 100 300 1,400 + 100 Output ↓

17. Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier Summary of Fiscal Policy Multipliers Policy Stimulus Multiplier Final Impact on Equilibrium Y Government spending multiplier Increase or decrease in the level of government purchases: ∆G Tax multiplier Increase or decrease in the level of net taxes: ∆T Balanced-budget multiplier Simultaneous balanced-budget increase or decrease in the level of government purchases and net taxes: ∆G = ∆T 1

18. Fiscal Policy at Work: Multiplier Effects The Balanced-Budget Multiplier 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.

19. The Budget The “budget” is really three different budgets: It is a political document that dispenses favours to certain groups or regions and places burdens on others. It is a reflection of goals the government wants to achieve. The budget may be an embodiment of some beliefs about how (if at all) the government should manage the macroeconomy.

20. The Budget The UK Budget in 2015-16 Government Receipts and Expenditure, 2015-16 £bn (totals may not sum due to rounding) Amount Current receipts Personal income taxes 295 Excise taxes and customs duties 274 Corporate income taxes 43 Council Tax 28 National Insurance 108 Fuel duty 25 Total 673 Current Expenditures Pensions 153 Welfare payments to persons 110 Health 134 Education 89 Interest payments 47 Defence 45 Total 742 Net Govt saving—surplus (+) or deficit (−) (Total current receipts − Total current expenditures) -70

21. The Budget The Budget in 2015-16 Budget surplus (+) or deficit (−) government receipts minus expenditures. The Government deficit is forecast to be £69.5bn in the fiscal year 2015-16 – a forecast subject to review in the latest budget and autumn statement.

22. The Government Debt national debt The total amount owed by the federal government. The sum total of all surpluses and deficits over time. The UK national debt is currently £1486 bn or 80% of GDP. This debt must be financed by issuing gilt-edged stock – which yield a rate of interest. Hence the interest payments on the expenditure side – of £47bn forecast for 2015-16. If interest rates rise, this debt repayment rises – one argument for reducing the debt levels. Higher interest rates may also be required to attract the funding.

23. The Economy’s Influence on the Government Budget Automatic Stabilizers and Destabilizers automatic stabilizers 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. automatic destabilizer Revenue and expenditure items in the federal budget that automatically change with the state of the economy in such a way as to destabilize GDP. fiscal drag The negative effect on the economy that occurs when average tax rates increase because taxpayers have moved into higher income brackets during an expansion.

24. The Economy’s Influence on the Government Budget Full-Employment Budget full-employment budget What the federal 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.

25. Key Terms • automatic destabilizers • automatic stabilizers • balanced-budget multiplier • budget deficit • cyclical deficit • discretionary fiscal policy • disposable, or after-tax, income (Yd) • Budget • National debt • Public sector surplus (+) or deficit (−) • fiscal drag • fiscal policy • full-employment budget • government spending multiplier • monetary policy • net taxes (T) • structural deficit • tax multiplier • 1. Disposable income Yd ≡ Y − T • 2. AE ≡ C + I + G • 3. Government budget deficit ≡ G − T • 4. Equilibrium in an economy with a government: Y = C + I + G • 5. Saving/investment approach to equilibrium in an economy with a government: S + T = I + G • 6. Government spending multiplier ≡ • 7. Tax multiplier ≡ • 8. Balanced-budget multiplier ≡ 1 MPS 1 MPC MPS