Transcript Offsets to Fiscal Policy

Offsets to Fiscal Policy
Side Effects (Offsets) to Fiscal Policy
Fiscal Policy not a perfect science/often trial and
error with expansionary and contractionary
fiscal policy
 Expansionary Policy- greater AD/less
unemployment but could lead to inflation
 Contractionary Policy- less inflation and lower
prices, but could lead to unemployment

HARD TO FIND THE PROPER COMBINATION
BETWEEN UNEMPLOYMENT AND LOW INFLATION
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Offsets to Fiscal Policy

1)
2)
3)
Fiscal Policy does not operate in a vacuumthere are consequences to these fiscal policy
decisions
If gov’t expenditures increase, how are these
expenditures financed, and by whom
If taxes increase, what does the gov’t do with
those taxes
What will happen if individuals worry about
future taxes because the gov’t is running up a
deficit?
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Offsets to Fiscal Policy
Direct
Crowding
Out
Indirect
Crowding
Out
Ricardian
Equivalence
Open-Economy Theorem
Effect
All of these offsets will have a diminishing or dampening
effect on expansionary fiscal policy!
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Possible Offsets to Fiscal Policy

Direct Crowding Out
◦ Direct expenditures offsets
 Any increase in government spending in an
area that competes with the private sector
Ex- Gov’t providing milk at no charge to students who
are already purchasing milk.
* Simply substituting “G” for “C”.
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Possible Offsets to Fiscal Policy
Indirect-Crowding Out- the tendency of expansionary
fiscal policy to cause a decrease in planned investment or
planned consumption usually due to a rise in interest rates
(interest rate effect)
Instead of sell bonds, gov’t could borrow from the loanable funds
market- result is the same (higher interest rates)
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The Supply of and
Demand for Loanable Funds
Annual Interest Rate
S1
1) What is the loanable
funds market?
2) Effect on the int.rate
by the gov’t borrowing
from the loanable
funds market?
ie
D2
D1
Qe
Quantity of Credit, or Loanable Funds,
per Time Period
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The Crowding-Out Effect
Either by selling bonds/borrowing from loanable funds
market, the effect is the same, increasing interest rates and a
dampening effect on AD.
LRAS
SRAS
Expansionary policy
causing deficit
spending initially
shifts AD to AD2.
E2
120
125
110
Due to crowding out
(higher interest rates),
AD shifts inward
to AD3.
E3
E1
AD1
0
6.5 7.0
6.75
AD2
AD3
Real National Income per Year
($ trillions)
Equilibrium GDP
below fullemployment GDP-contractionary gap
More “G” but less “C” and “I”
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Possible Offsets to Fiscal Policy
• The Open Economy Effect
 To increase “G”, deficit spending leads to an
increase in interest rates (sell bonds/borrow
loanable funds)
 Foreigners demand more U.S. securities as
interest rates go up. Must pay for it in U.S.
dollars.
 Demand for the dollar increases and supply of
foreign currency increases to purchase those U.S.
dollars.
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Possible Offsets to Fiscal Policy
• The Open Economy Effect
 Value of the dollar increases (appreciates)Remember stronger dollar
 Value of foreign currency decreases
(depreciates)
 American goods become more expensive
and foreign goods become cheaper
 Exports fall, imports rise
 Net exports fall- drop of “(X-M)- drop of AD
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Ricardian Equivalence Theorem

Belief that individuals take into account present
fiscal decisions for the future
Scenario- 1)Nation has balanced budget.
2) Nation wants to cut taxes but
also wants to keep gov’t spending at constant
levels.
Deficit is created!
Nation will be responsible to pay for
this in future.
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Ricardian Equivalence Theorem
Realizing the deficit (with interest) will have to
be paid back in the future with higher taxes,
individuals may wish to save tax cut.
 Therefore tax cut has no effect on AD or
economic growth.
 Similar situation- Gov’t spending increase, taxes
constant. Seeing future deficit people will save
and not spend.

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Supply-Side Economics.
1.
2.
3.
4.
Summarize the concepts behind supply-side
economics.
How does supply-side economics differ from
Keynesian fiscal policy?
What are the strengths and weaknesses of supplyside? Consider its effect on price level (inflation),
unemployment, output, economic growth.
What is the Laffer Curve? What is its significance?