The Government and Fiscal Policy

PRINCIPLE OF ECONOMIC

6 EDITION

KARL CASE, RAY FAIR

PRENTICE HALL BUSINESS PUBLISHING

COPY RIGHT 2002

 

Government in the Economy

•         Nothing arouses as much controversy as the role of government in the economy.

•         Government can affect the macroeconomy through two policy channels:  fiscal policy and monetary policy.

•         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.

•         Tax rates are controlled by the government, but tax revenue depends on changes in household income and the size of corporate profits, which the government cannot control.

•         Discretionary fiscal policy refers to changes in taxes or spending that are the result of deliberate changes in government policy.

Net Taxes (T), and Disposable Income (Y_d)

•         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 (Y_d) equals total income minus taxes.

The Budget Deficit

•         A government’s budget deficit is the difference between what it spends (G) and what it collects in taxes (T) in a given period:

•         If G exceeds T, the government must borrow from the public to finance the deficit.  It does so by selling Treasury bonds and bills.  In this case, a part of household saving (S) goes to the government.

The Tax Multiplier

•         A tax cut increases disposable income, which is likely to lead to added consumption spending.  Income will increase by a multiple of the decrease in taxes.

•         However, a tax cut has no direct impact on spending.  The tax multiplier for a change in taxes is smaller than the multiplier for a change in government spending.

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.

Adding the International Sector

•         We can think of imports (IM) as a leakage from the circular flow and exports (EX) as an injection into the circular flow.

•         With imports and exports, the equilibrium condition for the economy is:

                                                                                                              

•         The quantity (EX – IM) is referred to as net exports.  Increases or decreases in net exports can throw the economy out of equilibrium and cause national income to change.

The Economy’s Influence on the Government Budget

•         Tax revenues depend on the state of the economy.

•         Some government expenditures depend on the state of the economy.

•         Automatic stabilizers are 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.

•         Fiscal drag is the negative effect on the economy that occurs when average tax rates increase because taxpayers have moved into higher income brackets during an expansion.

•         The full-employment budget is a benchmark for evaluating fiscal policy.

•         The full-employment budget is what the federal budget would be if the economy were producing at a full-employment level of output.

The Economy’s Influence on the Government Budget

•         The cyclical deficit is the deficit that occurs because of a downturn in the business cycle.

•         The structural deficit is the deficit that remains at full employment.