Transcript Chapter 18 power point

Second Edition
Chapter 18
Fiscal Policy
Chapter Outline
 Fiscal Policy: The Best Case
 The Limits to Fiscal Policy
 When Fiscal Policy Might Make Matters
Worse
 So When Is Fiscal Policy a Good Idea?
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Introduction
 In 2008 the U.S. economy was falling
toward a severe recession
• S&P stock index was plummeting
• Third quarter of 2008 consumer spending
dropped by 3.7%.
 Two approaches were tried to encourage
spending:
• Tax rebate checks
• Large increase in government spending
 Both are examples of fiscal policy
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Introduction
 In This Chapter We…
• Use the dynamic aggregate demand and
aggregate supply model to understand fiscal
policy. We look at situations…
 In which fiscal policy is most effective.
 When fiscal policy doesn’t matter.
 When fiscal policy is harmful.
• Two general categories of fiscal policy
 The government spends more money.
 The government cuts taxes.
• In either case, the goal is greater spending.
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Fiscal Policy: The Best Case
 Effect of a decrease in consumer spending
growth,  C .
• This is equivalent to a decrease in velocity,  v
• What happens?
 AD shifts to the left
 Because wages are sticky, the decline in velocity is
split between lower real growth and lower inflation.
 The economy goes into a recession.
 Let’s use the model to show this and how fiscal
policy can restore full employment.
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Fiscal Policy: The Best Case
Inflation
rate
(p)
Solow
Growth
curve SRAS (pe = 7%)
7%
6%
(1) Consumers ↓AD →
↓real growth and↓ p
(a → b)
(2) Govt. ↑ spending
growth
(b → a)
a
b
(1)  C
(2)  G
AD(M  v  10%)
AD(M  v  5%)
-1% 0%
3%
Real GDP
growth rate
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Fiscal Policy: The Best Case
 If government did nothing, In the long-run
wages will adjust and C will return to its
normal growth rate.
• The economy will move from b → a.
• The recession will be over.
 The point of increasing G is to end the
recession sooner.
• Important question: If government ↑ spending
growth, where does the money come from?
 Let’s consider this next.
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Fiscal Policy: The Best Case
 Where Does the Money Come From?
• Higher taxes
• Increased borrowing
 In either case, other parts of AD will shrink
making the  G less effective.
 In the best case scenario…
• More spending creates growth which supports
increased spending.
• This is possible because the economy is
operating at less than full employment.
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The Multiplier
 Multiplier Effect – the additional increase in
AD caused when expansionary fiscal
policy increases income and thus
consumer spending.
• When government spends money, incomes of
certain people rise. As these people spend
their money, incomes of additional people rise
and so on.
• The greater the multiplier, the greater will be
the effect of the increase in G .
Let’s use our model to see this.
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The Multiplier
Inflation
rate
(p)
Solow
Growth
curve
Economy in
recession at point b:
(2) Govt. ↑ spending
a
growth
b→c
(3) Multiplier →  C
(3)  C
c→a
7%
6%
b
SRAS (pe = 7%)
(2)  G
(1)  C
AD(M  v  5%)
-1% 0%
3%
AD(M  v  10%)
Real GDP
growth rate
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Check Yourself
 What are the two types of
expansionary fiscal policy?
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The Limits to Fiscal Policy
 Four Major Limits to Fiscal Policy
1.
2.
3.
4.
Crowding out
A drop in the bucket
Timing
Real shocks
 Let’s look at each of these more closely.
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Crowding Out
 Crowding Out – The decrease in private
spending that occurs when government
increases spending.
 Crowding out can occur in two ways
depending on how government finances
the fiscal policy:
• Raises taxes
• Borrows the money by selling bonds.
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Crowding Out
 Government raises taxes to finance fiscal
policy
• Higher taxes reduce private spending.
• The greater the fraction of additional income
that consumers normally spend, the greater
will be crowding out.
 Implication: Fiscal policy will be most effective
when people are otherwise reluctant to spend their
own income.
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Crowding Out
 Government sells more bonds to finance
fiscal policy
• The supply of bonds increases.
 Bond prices fall → interest rates rise
 Higher interest rates → less private spending.
 Implication: Bond financed fiscal policy will be most
likely to be effective when the private sector is
reluctant to save or invest.
• because private spending will be less sensitive
to changes interest rates.
Let’s use the market for savings to see this.
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Increase in Government Borrowing
Crowds Out Private Spending
Interest rate
Supply of Savings
Government borrows
$100 billion
9%
b
c
7%
Reduced
private
investment
(borrowing)
Increased savings =
reduced consumption
a
Private Demand +
$100 billion
government demand
Private Demand
$150
$200
$250
Savings/Borrowing
(billions of dollars)
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Tax Rebates and Tax Cuts
 Tax Rebates
• Rebate – taxpayers are handed a check.
 Early 2008—Bush administration tried to stimulate
AD by sending a total of $78 billion in tax rebates:
$300-$600 per taxpayer.
 Result: AD did not increase at all because most of
the money was used to pay down debt.
 A problem with tax rebates is that they are not
permanent.
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Tax Rebates and Tax Cuts
 Cuts in tax rates have two expansionary
effects.
• Income effect – taxpayers have more
disposable income to spend.
• Incentive effect – taxpayers keep a greater
fraction of income resulting from increased
investment and work.
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Special Case of Crowding Out:
Recardian Equivalence
 Ricardian Equivalence – when people see
that lower taxes today mean higher taxes
later. They save their tax cut to pay future
taxes.
• Describes some people but not all.
• To the extent that this occurs, bond-financed
tax cuts are less effective in the short-run.
 The next diagram sums up the different
cases of crowding out.
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Limits to Fiscal Policy
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A Drop In the Bucket
 Normally changes in fiscal policy are small in
terms of percentage of GDP.
• Non-security discretionary spending is less than
20% of the federal budget.
 Stimulus plan passed under President Obama
in 2009—largest since WWII.
•
•
•
•
$800-900 billion
Spread over 3 - 4 years.
At its peak, only about 2% of annual GDP
In September 2010 – unemployment remained at
9.6%.
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A Matter of Timing
 By the time fiscal policy is in place,
economic conditions have often changed.
 Relevant lags:
• Recognition – Identification of the problem.
• Legislative – Congress must act.
• Implementation – Bureaucracies must carry
out the policy.
• Effectiveness – Policy takes time to work.
• Evaluation and adjustment—Did the policy
work? Have conditions changed?
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A Matter of Timing
 Example—Kennedy Tax Cut
• Discussed in 1961; Proposed in 1962;
Enacted in 1964.
• Lowered marginal rates from 91% to 70% at
the top and from 20% to 14% at the bottom.
• Rates in between were cut by about 30%.
• Results:
 Had little effect on the economy until 1965-1967.
 Long-term effect on economic growth was
significant.
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A Matter of Timing
 Example—Bush Tax Cuts
• Marginal rates were cut in 2001, 2002, and
2003.
• Each cut was less than 1% of GDP
• The economy was already recovering.
• Most went to relatively high income groups
who save a larger fraction of their income.
 Low income people pay little income tax.
• Result:
 Little effect on AD.
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A Matter of Timing
 Monetary policy is also subject to lags,
but…
• Generally are shorter than for fiscal policy.
• Federal Reserve can act very quickly.
 e.g. After 9/11, the next day the Fed stepped in with
massive infusions of cash to the banking system.
 Only advantage of fiscal policy is that the
effectiveness lag is shorter.
• Monetary policy depends on willingness of
banks to lend and businesses to borrow.
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A Matter of Timing
 Automatic Stabilizers—changes in fiscal
policy that stimulate AD in a recession w/o
explicit action by policy makers.
• Welfare and transfer programs
 In a recession more people apply for welfare
assistance and unemployment benefits → ↑ income
→ C
• Consumption smoothing
 People drawing on savings during an economic
downturn.
 Credit cards can help consumption smoothing
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Government Spending Versus Tax Cuts
As Expansionary Fiscal Policy
 Political differences
• Tax cut—puts more money into the private
sector, Bush (Republican) favored tax cuts.
• Spending—grows government, Obama
(Democrat) focused on spending.
 Economic differences
• Government spending is spending by
definition.
• Tax cuts will increase spending only if people
spend and don’t save their new money.
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Fiscal Policy Does Not Work Well to
Combat Real Shocks
 Real shocks reduce the productivity of
labor and capital
 Solow growth curve shifts to the left.
• Government responds by increasing G.
• Because the economy is at full employment
most of the increase in G will crowd out
private spending.
• Most of the effect shows up as ↑P.
• Let’s use our model to show how this works.
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Effect of a Real Shock
Inflation
rate
(p)
16%
(1) Solow growth curve shifts
left:
↑p → SRAS shifts up
↓ real growth rate →
recession: a → b
Old
Solow
growth
New Solow
growth curve c curve
(2)  G → ↑AD
Result:
Even higher p ;
Slightly higher
growth: b → c
Old SRAS
8%
2%
New SRAS
b
(2)  G
(1)
Real
shock
a
-3% -1%
3%
AD(M  v  15%)
AD(M  v  5%)
Real GDP
growth rate
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Check Yourself
 What happened to make the 2008 Bush
tax rebate less powerful than anticipated?
 Explain why a permanent cut in income
tax rates can create a larger fiscal stimulus
than a temporary cut?
 Keeping your answer to the previous
question in mind, why does a permanent
investment tax credit create a smaller
fiscal stimulus than a temporary
investment tax credit?
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When Fiscal Policy Might Make
Matters Worse
 If expansionary fiscal policy is paid for by
borrowing…
• Taxes will rise in the future.
• Higher future taxes will contract the economy.
 Ideal fiscal policy will increase AD in bad
times and pay off the debt in good times.
 Governments usually operate like this…
• Increase spending in bad times.
• Increase spending in good times.
• Result: Rising debt
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When Fiscal Policy Might Make
Matters Worse
 Interest payments on the debt can become a
large fraction of the budget.
 Excessive government borrowing can lead to
economic collapse.
 Example: Argentina
• Government debt rose to 150% of GDP.
• The country defaulted on its debt—the largest
default by a government in the history of the
world.
• Savings flowed out of the country to Miami and
other places.
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When Is Fiscal Policy a Good Idea?
 When dealing with an emergency
• War, Worsening depression, Natural disaster
 When crowding out is less likely.
 Fiscal policy is most likely to matter when:
• When the economy needs a short-run boost,
even at the expense of the long-run.
• When the problem is a demand shock not a
real shock.
• When many resources are unemployed.
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Takeaway
 Fiscal policy is most effective…
• In times of emergency
• When there unemployed resources
• When the economy needs a short-term boost.
 Fiscal policy is not good at boosting longterm growth.
 Fiscal policy sometimes doesn’t work…
• Because of “crowding out”.
• When people cut spending in fear of higher
future taxes—Ricardian Equivalence.
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Takeaway
 Most changes in government spending are not
big enough to make much of a difference.
 Automatic stabilizers help stabilize AD.
 Some countries take fiscal policy too far.
• Accumulate large amounts of debt
• This can destabilize finances, currencies, and
sometimes even governments.
 Good fiscal policy may not do a lot of good
 Bad fiscal policy can do a great deal of harm.
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Second Edition
End of Chapter 18