Lecture 9 Fiscal Policy Update

ECON1220: Introductory
Macroeconomics
Dr. Xiang Fang
Fall, 2021
Hong Kong University
Faculty of Business and Economics
CHAPTER
CHAPTER
16 Fiscal Policy
Chapter Outline and

Learning Objectives
16.1 What Is Fiscal Policy?
16.2 The Effects of Fiscal Policy on
Real GDP and the Price Level
16.3 Fiscal Policy in the Dynamic Aggregate
Demand and Aggregate Supply Model
16.4 The Government Purchases and Tax
Multipliers
16.5 The Limits of Using Fiscal Policy to
Stabilize the Economy
16.6 Deficits, Surpluses, and Federal Government
Debt
16.7 The Effects of Fiscal Policy in the Long Run
Appendix: A Closer Look at the Multiplier
© Pearson Education Limited 2015 2 of 68
Does Government Spending Create Jobs?
Government spending is a component of real GDP:
Y = C + I + G + NX
This makes it appear as though increases in government spending
increase output—and hence other relevant economic variables like
employment.
However some economists argue that government spending simply

shifts employment from one group to another—it does not increase
total employment.
• This debate was particularly important after the 2007-2009
recession: can the government use discretionary fiscal policy to
increase employment?

What is Fiscal Policy
16.1 LEARNING OBJECTIVE

Define fiscal policy.

Fiscal Policy Defined
Fiscal policy refers to changes in federal taxes and purchases that
are intended to achieve macroeconomic policy objectives.
(State taxes and spending are not generally aimed at affecting
national-level objectives.)
Some forms of government spending and taxes automatically

increase or decrease along with the business cycle; these are
automatic stabilizers.
Example: Unemployment insurance payments are larger during a
recession.
Discretionary fiscal policy, on the other hand, refers to intentional
actions the government takes to change spending or taxes.

How Much Government Spending Is Federal?
Before the Great Depression of the Figure 16.1 The federal government’s
1930s, most government spending share of total expenditures,
1929-2012
was at the state or local level;
now the federal government’s share
is two-thirds to three-quarters.
Federal Expenditures as a Percentage of GDP
Figure 16.2 Federal purchases and

As a percentage of GDP, federal federal expenditures as
expenditures are now higher than ever— a percentage of GDP,
almost 25% of GDP. 1950-2012
However a smaller proportion is now spent

on government purchases of goods and
services (mostly military spending).
What Does the Federal Government Spend Money On?
Federal purchases consist of

defense spending and “everything
else”, like salaries of FBI agents,
operating national parks, and
funding scientific research.
Around half of federal
expenditures are spent on
transfer payments, like Social
Security, Medicare, and
unemployment insurance.
The rest is spent on grants to
state and local governments to
support their activities, like crime
prevention and education; and on Figure 16.3 Federal government
paying interest on the federal expenditures, 2012
debt.
Where Does the Federal Government Get Money From?
The majority of federal

revenues come from taxes on
individual employment:
individual income taxes and
“payroll taxes” earmarked to
fund Social Security and
Medicare.
Taxes on corporate profits
constitute about one-seventh
of federal receipts.
The remainder of federal
revenue comes from excise
taxes (on cigarettes, gasoline,
etc.), tariffs on imports, and Figure 16.4 Federal government
revenue, 2012
other fees from firms and
individuals.
Making Social Security and Medicare: Fiscal Time Bombs?
the
Connection
Social Security and Medicare have helped to reduce poverty among
the elderly, while Medicaid helps improve the health of poor people.
• But the aging population and rising health care costs are
combining to put those programs in jeopardy.
• Through 2090, the budget shortfall for these programs is estimated
to be enormous: almost $60 trillion.

Making Social Security and Medicare: Is There a Fix?
the
Connection
How can these programs continue to exist?
It is likely that a combination of these measures will eventually need
to be adopted:
• Increasing taxes
• Decreasing benefits (including slower benefit growth, perhaps
differently for different income groups)
• Decreasing eligibility (SSI age already increasing from 65 to 67)
But perhaps the most important element will be finding a way to
reduce medical costs.

The Effects of Fiscal Policy on Real GDP and the Price
Level

Explain how fiscal policy affects aggregate demand and how the government
can use fiscal policy to stabilize the economy.

Expansionary Fiscal Policy in the AD-AS Model
Expansionary fiscal policy
involves increasing
government purchases or
decreasing taxes.
• Increasing government
purchases directly
increases aggregate
demand.
• Decreasing taxes indirectly
affects aggregate demand
by increasing disposable
income, and hence
consumption spending. Figure 16.5a Fiscal policy
If the government believes real GDP will be below potential GDP, it

can enact expansionary fiscal policy in an attempt to restore long-
run equilibrium—decreasing unemployment.
Contractionary Fiscal Policy in the AD-AS Model
Contractionary fiscal policy
involves decreasing
government purchases or
increasing taxes.
• This works just like
expansionary fiscal policy,
only in reverse.
Figure 16.5b Fiscal policy
If the government believes real GDP will be above potential GDP, it

can enact contractionary fiscal policy in an attempt to restore long-
run equilibrium—decreasing inflation.
Summarizing Fiscal Policy
Actions by Congress
Problem Type of Policy and the President Result
Recession Expansionary Increase government Real GDP and the price
spending or cut taxes level rise.
Rising inflation Contractionary Decrease government Real GDP and the price
spending or raise taxes level fall.
Table 16.1 Countercyclical fiscal policy
The federal government’s actions described on the previous slides

constitute a countercyclical fiscal policy.
Bear in mind that:
• The effects described assume ceteris paribus: everything else is
staying the same, including monetary policy.
• Contractionary fiscal policy is not really causing prices to fall; it’s
causing inflation to be lower than it otherwise would have been.
Fiscal Policy in the Dynamic Aggregate Demand and
Aggregate Supply Model

Use the dynamic aggregate demand and aggregate supply model to analyze
fiscal policy.

Static vs. Dynamic Model
Our model of fiscal policy so far is static: it assumes long-run potential
GDP does not change, and that the price level is constant.
While the lessons from this model are still appropriate—Congress and
the president can use fiscal policy to affect real GDP and the price
level—our understanding of fiscal policy can be improved by seeing it
in the dynamic aggregate demand and aggregate supply model.

Expansionary Fiscal Policy in the Dynamic AD-AS Model
Initially, the economy is in

long-run equilibrium.
• The federal government
projects that aggregate
demand will not rise by
enough to maintain full
employment.
• It enacts an expansionary
fiscal policy to increase
aggregate demand,
hopefully to the full
employment level.
The price level is higher
than it would have been Figure 16.6 An expansionary fiscal
without the expansionary policy in the dynamic model
fiscal policy.
Contractionary Fiscal Policy in the Dynamic AD-AS Model
The economy starts once

more in long-run equilibrium.
• The federal government
projects that aggregate
demand will rise so
much that employment
is beyond the full-
employment level,
causing high inflation.
• It enacts a contractionary
fiscal policy to decrease
aggregate demand, again
ideally to the full
employment level. Figure 16.7 A contractionary fiscal policy
in the dynamic model

The Government Purchases and Tax Multipliers

Explain how the government purchases and tax multipliers work.

Aggregate Demand and the Multiplier Effect
If the government
increases its
spending on goods
and services, then
aggregate demand
increases
immediately. This Figure 16.8
is the autonomous
The multiplier
increase in effect and
aggregate aggregate
demand
demand.
But then people receive this increased spending as increased income
and increase their consumption spending accordingly.
This is the induced increase in aggregate demand.
• The series of induced increases in consumption spending that
results from the initial increase in autonomous expenditures is
known as the multiplier effect.
Multiplier Effect of an Increase in Government Purchases
Suppose each increase in

spending induces half again as
much consumption spending.
• Over time, a $100 billion
increase in government
purchases will result in an
additional $100 billion in
induced consumption
spending.
Figure 16.9 The multiplier effect of an increase
in government purchases
Multipliers for Government Purchases and Taxes
We can describe the total effect of a change (increase or decrease) in
government purchases or taxes by measuring the change in
equilibrium real GDP.
Change in equilibrium real GDP
Government purchases multiplier 
Change in government purchases
Change in equilibrium real GDP

Tax multiplier 
Change in taxes
The tax multiplier will be a negative number: an increase in taxes will

decrease equilibrium real GDP, and vice versa.
We expect the tax multiplier to be smaller (in absolute value) than the
government purchases multiplier.
• Why? A $100 billion increase in purchases initially increases
spending by $100 billion, but a $100 billion tax cut is partially spent
and partially saved.
The Effect of Changes in Tax Rates
The tax multiplier applies to changes in the amount of taxes, without
changes in tax rates.
Example: In 2009 and 2010, the federal government enacted the
Making Work Pay Tax Credit: a $400 reduction in taxes for working
individuals ($800 for households).
Decreases in tax rates have a slightly different effect:

1. Increasing the disposable income of households, leading them to
increase their consumption spending.
2. Increasing the size of the multiplier effect, since more of any
increase in income becomes disposable income.

Taking into Account the Effects of Aggregate Supply
An increase in aggregate
demand will not only result
in real GDP rising; it will
also result in a price level
increase, because the
short-run aggregate supply
curve is upward-sloping.
Suppose that between the
autonomous and induced
effects, fiscal policy causes
aggregate demand to
increase by $1.2 trillion.
• The resulting real GDP
increase is smaller— Figure 16.10 The multiplier effect
only $1.0 trillion. The and aggregate supply
price level also rises.
The Multipliers Work in Both Directions
An increase in government purchases and a cut in taxes have a
positive multiplier effect.
A decrease in government purchases and an increase in taxes have a
negative multiplier effect.
Example: a reduction in government spending on defense initially

affects defense contractors, but then it would spread to suppliers to
and employees of those contractors, and then to other firms and
workers.

The Limits of Using Fiscal Policy to Stabilize the
Economy

Discuss the difficulties that can arise in implementing fiscal policy.

Can We Use Fiscal Policy to Stabilize the Economy?
For several reasons, fiscal policy may be even less effective than
monetary policy at countercyclical stabilization:
• Timing fiscal policy is harder, due to:
• Legislative delay: Congress needs to agree on the actions
• Implementation delay: Large spending projects may take
months or even years to begin, even once approved.
• Government spending might crowd out private spending
Crowding out: A decline in private expenditures as a result of an
increase in government purchases

Crowding Out in the Short Run—Money Market
A temporary increase in
government purchases
will cause the demand
for money, and hence
the interest rate, to rise.
But with the higher
interest rate,
consumption,
investment, and net
exports all fall.
Figure 16.11 An expansionary fiscal

policy increases
interest rates

Crowding Out in the Short Run—AD-AS Model
A temporary increase in
government purchases
will cause the demand
for money, and hence
the interest rate, to rise.
• With the higher
interest rate,
consumption,
investment, and net
exports all fall.
So the initial increase
in spending…
… is partially offset by
Figure 16.12 The effect of crowding
the crowding out. out in the short run

Crowding Out in the Long Run
In the long run, the increase in government purchases will have no
effect on real GDP; the reduction in consumption, investment, and net
exports will exactly offset the increase in government purchases.
• Why? Because in the long run, the economy returns to potential
GDP, even without the government’s intervention.
The long run effect is simply to increase the size of the government
sector within the economy.
• Bear in mind that the long run may be many years away, however,
so the intermediate increase in real GDP may be worth the cost.

Fiscal Policy in Action: The 2007-2009 Recession
In early 2008, believing a recession was imminent, Congress
authorized a tax cut: a one-time rebate of taxes already paid, totaling
$95 billion.
• This resulted in a boost to consumers’ current incomes. Changes
to current incomes result in smaller increases in spending than
changes to permanent incomes, because people seek to “smooth”
their consumption over time.
• Economists estimate that consumers spent about 33-40% of the
rebates they received, so the tax cut resulted in about $35 billion in
increased spending.

American Recovery and Reinvestment Act of 2009
Figure 16.13 The 2009 stimulus package
In 2009, Congress passed the “stimulus package”, a combination

of increased government spending (about two-thirds)…
… and decreased taxes (about one-third).
At $840 billion, the stimulus package was by far the largest fiscal
policy action in U.S. history.
The Effect of the Stimulus on the Federal Budget
The effect of the stimulus package on federal expenditures and
revenue was not immediate, but it mostly occurred over the following
two years.
(a) The effect on expenditures (b) The effect on revenues
Figure 16.14 The effect of the stimulus package

on federal expenditures and revenue
How Effective Was the Stimulus Package?
When the stimulus was passed, Obama administration economists
believed that by the end of 2010, it would:
• Increase real GDP by 3.5%
• Increase employment by 3.5 million
By the end of 2010, real GDP actually rose by 4.4% but employment
fell by 3.3 million.
Did the stimulus fail?

• To judge the effect of the stimulus package, we have to measure
its effects holding constant all other factors affecting real GDP and
employment.
• Isolating the effects of the stimulus package is very difficult;
economists still differ in their views about how effective the
stimulus package was.

CBO Estimates of the Effects of the Stimulus
Change in the Change in Employment
Year Change in Real GDP Unemployment Rate (millions of people)
2009 0.4% to 1.8% −0.1% to −0.5% 0.3 to 1.3
2010 0.7% to 4.1% −0.4% to −1.8% 0.9 to 4.7
2011 0.4% to 2.3% −0.2% to −1.4% 0.6 to 3.6
2012 0.1% to 0.8% −0.1% to −0.6% 0.2 to 1.3
2013 0.1% to 0.4% 0% to −0.3% 0.1 to 0.5
Table 16.2 CBO estimates of the effects

of the stimulus package
The Congressional Budget Office (CBO) is a non-partisan
organization that estimates the effects of government policies.
The table shows CBO estimates of the effect of the stimulus package
on economic variables, relative to what would have happened
without the stimulus package:
The CBO’s conclusion: the stimulus package reduced the severity of
the recession but did not come close to bringing the economy back to
full employment.
Making Why Was the Recession of 2007-2009 So Severe?
the
Connection
The recession of 2007-2009 was the worst recession to hit the United
States since the Great Depression of the 1930s.
Duration Decline in Real GDP Peak Unemployment Rate
Average for postwar recessions 10.4 months −1.7% 7.6%
Recession of 2007–2009 18 months −4.1% 10.0%
The Great Depression of the 1930s was accompanied by a financial

crisis—just like the recession of 2007-2009.
• Are recessions generally worse when they are accompanied by a
financial crisis?

Making The Recession of 2007-2009—continued
the
Connection
After studying recessions accompanied by financial crises worldwide,
economists Carmen Reinhart and Ken Rogoff say that such
recessions are much more severe than average:
Average Duration
Economic Variable Average Change of Change Number of Countries
Unemployment rate +7 percentage points 4.8 years 14
Real GDP per capita −9.3% 1.9 years 14
Real stock prices −55.9% 3.4 years 22
Real house prices −35.5% 6 years 21
Real government debt +86% 3 years 13
Note: Data above do not include the U.S. recession of 2007-2009.
Most people did not see the financial crisis coming, so they also
underestimated how severe the 2007-2009 recession would be.

Estimates of the Size of Multipliers
How large are the multipliers for government purchases and for
taxes? This question is very difficult to answer, and different
economists produce different estimates:
Economist Type of Size of Multiplier
Multiplier
Congressional Budget Office Government 0.5–2.5
purchases
Lawrence Christiano, Martin Government 1.05 (when short-term interest rates are not
Eichenbaum, and Sergio Rebelo purchases zero); 3.7 (when short-term interest rates are
expected to be zero for at least five quarters)
Tommaso Monacelli, Roberto Perotti, Government 1.2 (after one year) and 1.5 (after two years)
and Antonella Trigari, Universita Bocconi purchases
Ethan Ilzetzki, London School of Government 0.8
Economics, Enrique G. Mendoza, and purchases
Carlos A. Vegh, University of Maryland
Valerie Ramey, University of California, Military 0.6–1.1
San Diego expenditure
Robert J. Barro, Harvard University, and Military 0.4–0.5 (after one year)
Charles J. Redlick, Bain Capital, LLC expenditure and 0.6–0.7 (after two years)
Table 16.3 Estimates of the size of

© Pearson Education Limited 2015 the multiplier 39 of 68
Estimates of the Size of Multipliers—continued
Economist Type of Multiplier Size of Multiplier

John Cogan and John Taylor, Stanford A permanent increase 0.4
University, and Tobias Cwik and in government
Volker Wieland, Gothe University expenditures
Christina Romer, University of A permanent increase 1.6
California, Berkeley, and Jared in
Bernstein, chief economist and government
economic policy adviser to Vice expenditures
President Joseph Biden
Christina Romer (prior to serving as Tax 2–3
chair of the Council of Economic
Advisers) and David Romer,
University of California, Berkeley
Congressional Budget Office Tax 0.6–1.5 (two-year tax cut for lower-
and middle-income people) and
0.1–0.6 (one-year tax cut for
higher-income people)
Robert J. Barro, Harvard University, Tax 1.1
and Charles J. Redlick, Bain Capital,
LLC
Table 16.3 continued Estimates of the size of

© Pearson Education Limited 2015 the multiplier 40 of 68
Deficits, Surpluses, and Federal Government Debt

Define federal budget deficit and federal government debt, and explain how the
federal budget can serve as an automatic stabilizer.

The Federal Budget Deficit, 1901-2013
The U.S. federal government does not generally balance its budget.
Sometimes its revenues are higher than its expenditure, but usually
the reverse is true—especially during wartime.
Figure 16.15 The federal budget

deficit, 1901-2013
Budget Deficits and Surpluses
A budget deficit occurs when the government’s expenditures are
greater than its tax revenue.
A budget surplus occurs when the government’s expenditures are
less than its tax revenue.
As the graph on the previous slide indicates, budget deficits often
occur during wartime.
• But they also occur during recessions, as tax receipts fall, and
automatic stabilizers like increases in transfer payments
(unemployment insurance, food stamps, etc.) take effect.
• These automatic stabilizers are important for limiting the severity of
a recession; many economists believe that the Great Depression of
the 1930s was more severe because most of these automatic
stabilizers did not exist then.

How Large Is the Deficit in the United States?
Currently, the federal government runs a budget deficit; the CBO
estimated in 2013 that the deficit for 2014 would be about 3.5% of
real GDP.
• How much of this deficit is due to the recession, and how much is
due to government spending and tax policies?
We can identify this by looking at the cyclically adjusted budget

deficit or surplus: the deficit or surplus in the federal government’s
budget if the economy were at potential GDP.
• The CBO estimated that the budget deficit would be 1.0% of real
GDP in 2014 if real GDP were at its potential.
• So this is the amount that spending needs to be cut, or taxes
raised, in order to bring the federal budget into balance in the long
run. The rest is due to automatic stabilizers.
Making Did Fiscal Policy Fail during the Great Depression?
the
Connection
Government expenditures increased after
the Great Depression of the 1930s as part
of the “New Deal”, enacted by Franklin D.
Roosevelt.
• Similarly, there was a budget deficit
each year in the 1930s (except 1937).
However recovery from the Great
Depression was painfully slow.
• Does this show that expansionary
fiscal policy didn’t work during the
1930s?
In fact, when we cyclically-adjust the
budget deficits of the 1930s, we find that
the federal government was not using
expansionary fiscal policy at all. It had a
cyclically adjusted budget surplus instead.
Making
the Fiscal Policy during the Great Depression
Connection
Federal Actual Federal Cyclically Adjusted Cyclically Adjusted
Government Budget Deficit Budget Deficit Budget Deficit or
Expenditures or Surplus or Surplus Surplus as a
Year (billions of dollars) (billions of dollars) (billions of dollars) Percentage of GDP
1929 $2.6 $1.0 $1.24 1.20%
1930 2.7 0.2 0.81 0.89
1931 4.0 −2.1 −0.41 −0.54
1932 3.0 −1.3 0.50 0.85
1933 3.4 −0.9 1.06 1.88
1934 5.5 −2.2 0.09 0.14
1935 5.6 −1.9 0.54 0.74
1936 7.8 −3.2 0.47 0.56
1937 6.4 0.2 2.55 2.77
1938 7.3 −1.3 2.47 2.87
1939 8.4 −2.1 2.00 2.17
E. Cary Brown: “Fiscal policy, then, seems to have been an

unsuccessful recovery device in the ‘thirties—not because it did not
work, but because it was not tried.”
Should the Federal Budget Always Be Balanced?
Although many economists believe the federal budget should be
balanced when the economy is at potential GDP, few believe it should
be balanced during a recession.
• During a recession, tax revenues fall; to balance the budget,
spending would have to fall also—making the recession worse.
In fact, some economists argue that the federal budget should

normally be in deficit. Just as households and firms borrow money to
implement long-term investments, they argue that the federal
government should do the same.

Federal Government Debt
When the federal
government runs a budget
deficit, it finances its
activities by selling
Treasury securities.
The total value of those
securities outstanding is
known as the federal
government debt, or the
national debt.
The national debt increased
dramatically as a percentage
of GDP during the two world
wars and the two worst
recessions. It is now at its
highest level since 1947. Figure 16.16 The federal government
debt, 1901-2013
Is Government Debt a Problem?
For now, the federal government is at no serious risk of defaulting on
its obligations, because:
• The interest rate it can borrow money at is very low
• The size of the interest payments on the debt is low relative to the
size of the federal budget—around 11%
In the long run, a debt that increases in size relative to GDP can pose
a problem—potentially crowding out investment, which is a key
component of long term growth.
• This problem is reduced if the government debt was incurred to
finance infrastructure, education, or research and development;
these serve as a long term investment for the economy.

The Effects of Fiscal Policy in the Long Run

Discuss the effects of fiscal policy in the long run.

Long-Run Fiscal Policy
The fiscal policy we have concentrated on so far was intended to
address short-run goals of stabilizing the economy.
• But other fiscal policy actions are intended to have long-run
impacts on potential GDP—i.e. on aggregate supply, rather than
aggregate demand.
• Hence these actions are often referred to as supply-side
economics.
Most such policies are based on changing taxes in order to increase

incentives to work, save, invest, and start a business.

The Long-Run Effects of Tax Policy
Most taxes are assessed as a percentage of some economic activity,
like individual income, corporate income, or capital gains.
• When an individual decides how much to work, he bases the
decision on how much an hour of work will increase his ability to
consume goods and services—the post tax wage.
• When a firm decides how many people to employ, it considers how
much it has to pay in total for each worker: the pretax wage.
The difference between these is an example of a tax wedge: the

difference between the pretax and post tax return to an economic
activity.
• A large tax wedge distorts the incentives of individuals and firms to
take part in economic activities, generally resulting in lower levels
of economic activity—lower real GDP.
Tax Rates Matter
Tax rates matter because the larger they are, the larger will be the
behavioral response to the tax:
Individual income tax
• Affects labor supply decisions and the returns to
entrepreneurship
Corporate income tax
• Affects the incentives of firms to engage in investment
Tax on dividends and capital gains
• Affects the supply of loanable funds from households to firms,
and hence the real interest rate
• Also affects the way firms disburse profits—2003 reduction in
dividend tax led some firms like Microsoft to pay dividends for
the first time
Tax Simplification
Simpler taxes would also lead to economic gains for society.
• The current tax code is extremely complicated—over 3,000 pages
long.
• The IRS estimates that taxpayers spend more than 6.4 billion
hours each year filling out their tax returns—45 hours per tax
return.
• A simplified tax code would increase economic efficiency by
reducing the number of decisions households and firms make
solely to reduce their tax payments.

The Economic Effect of Tax Reform
Tax reform has
the potential to
significantly increase
real GDP in the long
run beyond the
increases that would
otherwise occur.
• The magnitude of
the effect is
uncertain,
however.
For example, while people Figure 16.17 The supply-side effects
might like to work more if tax of a tax change
rates are lowered, they might be constrained by employers expecting
a particular work week (like 40 hours). Economists believe that more
study is needed on the impact of tax reforms.
How Large are Supply-Side Effects?
While decreasing tax rates would likely result in more economic
activity, the magnitude of the effect is debatable.
• Workers may not be able to change their work hours very much
• Savings and investment may not be affected much by tax rates
So the majority of the effect of tax rate cuts may come through
aggregate demand.
The debate over the magnitude of supply-side effects can only be

resolved through careful study.
• But even recent work by leading economists has conflicting
conclusions.
• Hopefully, further study will bring estimates closer together.

Common Misconceptions to Avoid
Fiscal policy and monetary policy have similar goals but are different
in their methods. Don’t confuse the two.
Deficit and debt are not the same. A deficit is the revenue shortfall in
a given year, while the debt is the accumulation of prior deficits.
A balanced budget is not necessarily good; a budget deficit is not

necessarily bad.
Government purchases and tax multipliers are for the short run; the
long run multipliers are necessarily zero. But just because they are
effective only in the short run, does not mean they are unimportant:
the short run matters too!

Appendix: A Closer Look at the Multiplier
LEARNING OBJECTIVE
Apply the multiplier formula.

A Closer Look at the Multiplier
Our objective in this appendix is to develop an econometric model for
how real GDP is determined.
Then we will use that model to identify:
1. The government purchases and tax multipliers
2. How those multipliers are altered by tax rates
3. How those multipliers change in an open economy, i.e. when net

exports change in response to income changes.
Throughout, we will assume that price levels do not change.

Finding Equilibrium GDP (Simple Version)—setup
For simplicity, we will initially assume that taxes do not depend on
income (i.e. they are a fixed amount), there are no government
transfers to households, and there are no imports or exports.
(1) C = 1,000 + 0.75(Y − T) Consumption function
(2) I = 1,500 Planned investment function
(3) G = 1,500 Government purchases function
(4) T = 1,000 Tax function
(5) Y = C + I + G Equilibrium condition
These numbers are in billions of dollars, except the marginal

propensity to consume (MPC) of 0.75.
(Y-T) is disposable income.
Then we can write:
Y = 1,000 + 0.75(Y − 1,000) + 1,500 + 1,500

Finding Equilibrium GDP (Simple Version)—cont.
Y = 1,000 + 0.75(Y − 1,000) + 1,500 + 1,500
= 1,000 + 0.75Y − 750 + 1,500 +
1,500
Subtracting 0.75Y from both sides, we obtain:
Y − 0.75Y = 1,000 − 750 + 1,500 + 1,500

0.25Y = 3,250
3,250
Y 13,000
0.25
Thus we conclude that according to our model, real GDP will be $13
trillion.

An Algebraic Expression for Equilibrium Real GDP
Instead of inserting numbers, we could find an expression for real
GDP algebraically. Let:
(1) C = C + MPC(Y − T) Consumption function
(2) I = I Planned investment function
(3) G = G Government purchases function
(4) T = T Tax function
(5) Y = C + I + G Equilibrium condition
(The letters with bars represent fixed or autonomous variables.)

Then: Y C  MPC (Y  T )  I  G
Y  MPC (Y ) C  ( MPC T )  I  G
Y (1  MPC ) C  ( MPC T )  I  G
C  ( MPC T )  I  G
Y
1  MPC

A Formula for the Government Purchases Multiplier
Any change in an autonomous variable will change the value of real
GDP (Y). We can make that explicit by writing the variables in change
form:
C  ( MPC T )  I  G
Y 
1  MPC
This uses the standard notation of ∆ for “change”.
Keeping autonomous consumption (C), taxes (T), and investment (I)
constant, we get:
G
Y 
1  MPC
Divide both sides by ∆G to obtain the government purchases
multiplier: Y 1

G 1  MPC

A Formula for the Tax Multiplier
Let’s start again with the algebraic expression for real GDP:
C  ( MPC T )  I  G
Y 
1  MPC
Now we will keep autonomous consumption (C), investment (I), and
government purchases (G) constant:
 MPC T
Y 
1  MPC
Divide both sides by ∆T to obtain the tax multiplier:

Y  MPC

T 1  MPC
For example, if MPC = 0.75, the tax multiplier will be:
 0.75
 3
1  0.75
A $10 billion increase in taxes decreases real GDP by $30 billion.
The “Balanced Budget” Multiplier
Suppose we increase government spending and taxes both by $10
billion. What would happen to real GDP?
Increase in real GDP from the  $10 billion  1
increase in government purchases 1  MPC
Decrease in real GDP from the  MPC

 $10 billion 
increase in taxes 1  MPC
Adding these effects and factoring out the $10 billion gives:
 1    MPC  
$10 billion      
 1  MPC   1  MPC 
We can simplify this to:
 1  MPC 
$10 billion    $10 billion
 1  MPC 
So the balanced budget multiplier is 1: equal dollar increases in
government spending and taxes increase real GDP by that amount—
at least, in the short run.
Incorporating Tax Rates
In our model, taxes were autonomous. Now, we will make them
depend on income. Assuming a tax rate of t, consumers will now have
disposable incomes of (1-t)Y.
So the consumption function changes to:
C C  MPC (1  t )Y
Going through the same steps as before, we can obtain:
Y 1
Government purchases multiplier  
G 1  MPC (1  t )
If MPC = 0.75 and t = 0.2, then:
Y 1 1
Government purchases multiplier    2.5
G 1  0.75(1  0.2) 1  0.6
If the tax rate t falls to 0.1, the multiplier becomes:
Y 1 1
G 1  0.75(1  0.1) 1  0.675
So lower tax rates yield larger multipliers.
The Multiplier in an Open Economy
Now suppose we have imports and exports. Assume exports are
autonomous, but the level of imports depends on income:
Exports Exports Imports MPI Y
Here MPI is the marginal propensity to import: the fraction of

additional income spent on imported goods.
Now we can write net exports as [ Exports  ( MPI Y )]
Inserting this into our equation for equilibrium real GDP we get:
Y C  MPC (1  t )Y  I  G  [ Exports  ( MPI Y )]
Following the same process as before, we can obtain a new

expression for the government purchases multiplier:
Y 1
G 1  [ MPC (1  t )  MPI ]

The Multiplier in an Open Economy—continued
Y 1
G 1  [ MPC (1  t )  MPI ]
Let MPC = 0.75, t = 0.2, and MPC = 0.1. Then:
Y 1 1
Government purchases multiplier    2
G 1  (0.75(1  0.2)  0.1) 1  0.5
This is smaller than the multiplier from before; a portion of spending
goes on imports, which do not feed back in to higher income in our
country.
If MPI increases to 0.2, then we have:

Y 1 1
G 1  (0.75(1  0.2)  0.2 1  0.4
This is smaller still. An increase in the amount of additional income

leaving the country as payments for imports decreases the multiplier
effect of additional government purchases.
Addendum
• Rising government debt
• Many faces of government debt
• Debt and sustainability
• Debt and the international financial market
Debt is perhaps one of the most important macroeconomic topics of

our time.

Rising Government Debt

Many Faces of Government Debt
• Borrowing of government --- who are the lenders?
• Financial institutions under regulation
• Financial institutions with liquidity management concerns
• Retail investors and households
• Government debt: liquidity and convenience
• Liquidity and convenience lowers the interest rate
• An argument on why US public debt is still sustainable
• Government debt: may also bring risks to the economy
• Rising government debt introduces future fiscal risks and uncertainty that
hampers long-term growth
• Government, especially emerging market government, may excessively
issue debt that leads to sovereign default

Debt Sustainability
• What is a sustainable public debt?
• Future government expenditure and tax revenue
• The interest rate, or the required return by investor
• A high level of debt is sustainable if
• Future government surplus increases faster than the interest rate

Debt and International Financial Market
• US and other major economies are enjoying an “exorbitant
privilege” in the international financial system
• Investors perceive US Treasuries as the most liquid and safest asset in the
world, so they hoard US Treasuries for liquidity, safety, and to satisfy
regulators’ requirements
• The “exorbitant privilege” enables them to issue more debt
• The “exorbitant privilege” lowers the financing cost of US government, as
well as other major economies’ government
• But excessive debt can be detrimental for the “exorbitant privilege”
• The “exorbitant privilege” comes from the asset itself being safe and liquid.
Excessive debt makes the Treasury no longer safe --- that could trigger the
loss of “exorbitant privilege”. Is there such a tipping point? Where is it?

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ECON1220: Introductory

Chapter Outline and

However some economists argue that government spending simply

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16.1 LEARNING OBJECTIVE

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Some forms of government spending and taxes automatically

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Figure 16.2 Federal purchases and

However a smaller proportion is now spent

Federal purchases consist of

The majority of federal

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16.2 LEARNING OBJECTIVE

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If the government believes real GDP will be below potential GDP, it

Figure 16.5b Fiscal policy

If the government believes real GDP will be above potential GDP, it

Table 16.1 Countercyclical fiscal policy

The federal government’s actions described on the previous slides

16.3 LEARNING OBJECTIVE

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Initially, the economy is in

The economy starts once

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16.4 LEARNING OBJECTIVE

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Suppose each increase in

Change in equilibrium real GDP

The tax multiplier will be a negative number: an increase in taxes will

Decreases in tax rates have a slightly different effect:

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Example: a reduction in government spending on defense initially

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16.5 LEARNING OBJECTIVE

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Figure 16.11 An expansionary fiscal

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Figure 16.13 The 2009 stimulus package

In 2009, Congress passed the “stimulus package”, a combination

(a) The effect on expenditures (b) The effect on revenues

Figure 16.14 The effect of the stimulus package

Did the stimulus fail?

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Table 16.2 CBO estimates of the effects

The Great Depression of the 1930s was accompanied by a financial

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Note: Data above do not include the U.S. recession of 2007-2009.

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Table 16.3 Estimates of the size of

Economist Type of Multiplier Size of Multiplier

Table 16.3 continued Estimates of the size of

16.6 LEARNING OBJECTIVE