Transcript fiscal policy - McGraw

Chapter 14
AGGREGATE DEMAND
POLICY IN PERSPECTIVE
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-2
Today’s lecture will:
• Identify six problems with fiscal policy
•
•
•
and explain how those problems limit its
use.
Describe how automatic stabilizers work.
Summarize the advantages and
disadvantages of using monetary and
fiscal policy.
Discuss why economists often talk about
policy regimes rather than simply policy.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-3
Supply Side versus
Demand Side Policies
• The interrelationship between AS and AD
is captured in the circular flow diagram.
 AS creates an output and income, and hence
the potential AD to buy that output.
• The AS/AD model separates long-run AS
from short-run AD forces.
 Demand-side policies (monetary and fiscal
policies) shift the AD curve.
 Supply-side policies work by increasing
potential output.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-4
Problems with Fiscal Policy
• Six assumptions of the AS/AD model lead
to problems with fiscal policy:
 Financing the deficit has no offsetting effects.
 The government knows what the situation is.
 The government knows potential income.
 The government has flexibility in changing
spending and taxes.
 The size of the government debt doesn’t
matter.
 Fiscal policy doesn’t negatively affect other
goals.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-5
Financing the Deficit Doesn’t
Have Offsetting Effects
• Some economists believe that
•
government financing of deficit spending
offsets the deficit’s expansionary effect.
Crowding out – the offsetting of a change
in government expenditures by a change
in private expenditures in the opposite
direction due to higher interest rates
caused by government borrowing.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-6
Partial Crowding Out
AD2 AD1
AD0
Price Level
SAS
Partial crowding out
Net effect
Y0
McGraw-Hill/Irwin
Y2
Y1
Real output
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-7
Knowing What the Situation Is
• Data problems limit the use of fiscal
policy for fine tuning.
 Getting reliable numbers on the economy
takes time.
 We may be in a recession and not know it.
• The government has large econometric
models and leading indicators to predict
where the economy will be in the future,
but the forecasts are imprecise.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-8
Knowing the Level
of Potential Income
• No one knows for sure the potential (full•
•
employment) income.
Almost all economists believe that
potential income is within an
unemployment rate range between 3.5% to
10%.
Differences in estimates of potential
income often lead to different policy
recommendations.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-9
Flexibility in Changing
Taxes and Spending
• Putting fiscal policy into place takes time
•
•
and has serious implementation problems.
Numerous political and institutional
realities make it a difficult task to
implement fiscal policy.
Disagreements between Congress and the
President may delay implementing
appropriate fiscal policy for months, even
years.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-10
Size of the Government
Debt Doesn’t Matter
• Although there is no inherent reason
why activists policies should have
caused persistent deficits, increases in
government debt has occurred because:
 Early activists favored not only the use of
fiscal policy, but also large increases in
government spending.
 Politically it’s easier for government to
increase spending and decrease taxes than
vice versa.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-11
Fiscal Policy Doesn’t
Negatively Affect Other Goals
• A society has many goals: achieving
•
•
potential income is only one of those
goals.
National economic goals may
conflict.
For example, when the government
runs expansionary fiscal policy, the
trade deficit increases
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-12
Building Fiscal Policy
into Institutions
• To avoid the problems of direct fiscal policy,
•
•
economists have attempted to build fiscal
policy into U.S. institutions.
Automatic stabilizers – any government
program or policy that will counteract the
business cycle without any new government
action.
Automatic stabilizers include:
 welfare payments
 unemployment insurance
 the income tax system.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-13
How Automatic Stabilizers Work
• When the economy is in a recession, the
•
•
•
unemployment rate rises.
Unemployment insurance is automatically paid
to the unemployed, offsetting some of the fall
in income.
Income tax revenues also decreases when
income falls in a recession, providing a
stimulus to the economy.
Automatic stabilizers also work in reverse.
 When the economy expands, government spending
for unemployment insurance decreases and taxes
increase.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-14
State Government Finance and
Procyclical Fiscal Policy
• State constitutional provisions mandating
balanced budget act as automatic
destabilizers.
 During recessions states cut spending and raise

taxes.
During expansions states increase spending and
cut taxes.
• Procyclical fiscal policy – changes in
government spending and taxes that increase
the cyclical fluctuations in the economy
instead of reducing them.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-15
State Government Finance
and Procyclical Policy
• Economists have suggested alternatives to
•
•
state government procyclical budget policy.
States can establish rainy season fundsreserves kept in good times to offset
declines in revenues during recessions.
States could use a five-year rolling-average
budgeting procedure as the budget they are
required to balance.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-16
Automatic Stabilizers Have
Their Problems
• When the economy first starts climbing
•
out of a recession, automatic stabilizers
may slow down the process.
Despite these problems, most economists
feel that automatic stabilizers have played
an important role in reducing fluctuations
in the economy.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-17
Percent change in real GDP
around the trend
Has Demand Management
Reduced Fluctuations?
20%
15
10
5
0
5
10
15
20
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Before demand
management
McGraw-Hill/Irwin
Active demand
management
Modern period
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-18
Conventional Wisdom about
Monetary and Fiscal Policy
• Monetary and fiscal policy are not tools to fine•
•
tune the economy, but they can be useful in
guiding it toward the macroeconomic goals.
Monetary policy is more important in the shortrun because it is more flexible and less
influenced by politics.
Long-run consequences of expansionary
policy include:
 Inflation (monetary policy)
 Higher interest rates and crowding out (fiscal
policy)
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-19
Conventional Wisdom about
Monetary and Fiscal Policy
Option
Monetary Expansionary
policy
Contractionary
McGraw-Hill/Irwin
Advantages
Disadvantages
1. Interest rates may fall.
2. Economy may grow.
3. Decreases unemployment.
1. Inflation may worsen.
2. Capital outflow.
3. Trade deficit may
increase.
1. Helps fight inflation.
2. Trade deficit may increase.
3. Capital inflow
1. Risks recession.
2. Increases unemployment.
3. Slows growth.
4. May help cause short-run
problems.
5. Interest rates may rise.
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-20
Conventional Wisdom about
Monetary and Fiscal Policy
Option
Fiscal
policy
Expansionary
Contractionary
McGraw-Hill/Irwin
Advantages
Disadvantages
1. May increase output growth
in the short run.
2. May help solve short-run
political problems.
3. Decreases unemployment.
1. Budget deficit worsens.
2. Hurts country’s ability to
borrow in the future.
3. Trade deficit may increase.
4. Upward pressure on interest
rate, discouraging growth.
1. May help fight inflation.
2. May allow a better
monetary/fiscal mix.
3. Trade deficit may decrease.
4. Interest rates may fall,
stimulating investment and
growth in the long run.
1. Risks recession.
2. Increases unemployment.
3. Slows output growth in the
short run.
4. May help cause short-run
political problems.
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-21
Alternatives and Supplements
to Monetary and Fiscal Policy
• Any policy that affects autonomous
•
spending without having offsetting
effects on other expenditures can
achieve the same results.
Alternatives and supplements to
monetary and fiscal policy include:
 Directed investment policies
 Trade policy
 Consumption policy
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-22
Directed Investment Policies:
Policies Affecting Expectations
• Rosy scenario – government policy
of making optimistic predictions and
never making gloomy predictions.
 Gloomy government predictions can
affect expectations and decrease
investment and consumption spending.
• Government guarantees or promises
of guarantees can bolster business
confidence.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-23
Autonomous Consumption Policy
• Making credit more available to
•
consumers can expand aggregate
demand.
Economists watch indexes of
consumer credit and consumer
confidence to gauge the direction of
the economy.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-24
Trade Policy and
Export-Led Growth
• Export-led growth policies – policies designed
•
•
to stimulate U.S. exports and increase
aggregate expenditures on U.S. goods.
Policies that restrict imports have the same
expansionary effect on income.
Because global economies are independent,
there is a risk of retaliation whenever a nation
applies trade restrictions against another
nation.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-25
Exchange Rate Policies
• Exchange rate policy – a policy of
•
deliberately affecting a country’s
exchange rate in order to affect its
trade balance.
A low value of a country’s currency
relative to other currencies
encourages exports and discourages
imports, and vice versa.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-26
Credibility in Aggregate
Demand Policy
• What people believe about policy
•
•
significantly influences the effectiveness
of that policy.
Because changes in expectations can
shift the AD curve, expectations
complicate models and policymaking.
Effective policy must be credible policy.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-27
Rational Expectations
• Rational expectations – forward-looking
•
•
expectations that use available
information.
If the public is convinced that the Fed’s
sole goal is controlling inflation, the
policy will be effective.
People will react differently if they
believe that the Fed is resolute about
fighting inflation.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-28
Uncertainty About the
Effects of Policy
• The central role of expectations means
•
•
•
that there is a great deal of uncertainty in
the economy.
What people believe is important in how
they react to policy.
How people react to policy determines
how monetary and fiscal policy will work.
Because people have different
expectations, the impact of various
polices is difficult to predict.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-29
Policy Regimes and Expectations
• A policy regime is a rule.
 It is a predetermined statement of the policy that will
•
be followed in various circumstances.
A policy is a one-time reaction to a problem.
 It is chosen without a predetermined framework.
• Policy regimes can help generate the
•
expectations that make the government’s tools
work.
The focus on credibility has led to a call for
rules to guide policy rather than giving
policymakers wide policy discretion.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-30
•
•
•
Summary
Fiscal policy is affected by the following problems:






Interest rate crowding out.
The government may not know what the situation is.
The government may not know the economy’s potential
income.
Government can not respond quickly.
The size of the government debt does matter.
Economic goals may conflict.
Activist policy is now built into U.S. institutions
through automatic stabilizers.
Economists’ challenge is to find the appropriate
mix of policy to balance the trade-off between low
unemployment, high growth, and low inflation.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-31
Summary
• Three alternatives to monetary and fiscal policy
are:
 Directed investment policies
 Autonomous consumption policy
 Trade policy
• Policy is a process, not a one-time event, and
•
policy regimes are often more important than
any particular policy.
Credibility can be built by establishing policy
rules, but the trade-off is that policymakers will
be unable to respond to an unforeseen event.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
14-32
Review Question 14-1 Identify three automatic stabilizers and explain how
they would lessen the severity of a recession.
Welfare payments, unemployment insurance, and income tax are automatic
stabilizers. In the case of a recession, unemployment increases, so welfare
payments and unemployment insurance increase, offsetting some of the
decrease in income. With lower incomes, people pay less tax. An increase
in government spending and a decrease in taxes is an expansionary policy
that will increase AD.
Review Question 14-2 What are the six assumptions of the AS/AD model
that lead to problems with fiscal policy?
1. Financing the deficit has no effect. (It can cause crowding out).
2. The government knows what the situation is. (The government uses
estimates of the mpe and other exogenous variables.
3. The government knows potential income. (There is a wide range of
estimates).
4. The government has flexibility in changing spending and taxes.
5. Size of the debt doesn’t matter.
6. Fiscal policy doesn’t affect other economic goals.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.