Recaping the effects of both Fiscal policy and Monetary policy in the long run

Transcription

1 Recaping the effects of both Fiscal policy and Monetary policy in the long run When the government ran a record surplus in 2000, many regarded it as a cause for celebration. Conversely, people usually think of deficits as bad: when the Congressional Budget Office projected a record deficit for 2009, many people regarded it as a cause for concern. How do surpluses and deficits fit into the analysis of fiscal policy? Are deficits ever a good thing and surpluses a bad thing? To answer those questions, we need to look at the causes and consequences of surpluses and deficits. 1

2 Recall that the Budget Balance is the difference between the government s tax revenue and its spending. T= value of tax revenues G = government purchases of goods and services TR = value of government transfers The three aspects of fiscal policy! A budget surplus is a positive budget balance, and a budget deficit is a negative budget balance. 2

3 The economy tends to move into deficit when the it is experiencing a recession, but deficits tend to get smaller or even turn into surpluses when the economy is expanding. Remember that automatic stabilizers are when government tax revenue tends to rise and some government transfers, like unemployment benefit payments, tend to fall when the economy expands. Conversly, government tax revenue tends to fall and some government transfers tend to rise when the economy contracts. So the budget tends to move towards surplus duringexpansions and toward deficit duringrecessions recessions even without any deliberate action on the part of policy makers. We need to separate movements in the budget balance due to the business cycle (which is affected by automatic stabilizers) and discretionary fiscal policy changes. Removing the business cycle s effect on the budget balance tells us whether our government s tax policies will create enough revenue to sustain our spending in the long run. The government will estimate what the budget balance would be if there were in neither a recessionary nor inflationary gap! Meaning that they would estimate what the budget balance would be at potential output! 3

4 ?? Most economists don t think it should be adjusted yearly, but on average Why? The tendency of tax revenue to fall and transfers to rise when the economy contracts helps to limit the size of recessions. But falling tax revenue and rising transfer payments push the budget toward deficit. If constrained by a balance budget rule, the government would have to respond to this deficit with contractionary fiscal policies that would tend to deepen a recession. Nonetheless, policy makers who are concerned about excessive deficits feel that rigid rules, or at least an upper limit on deficits is necessary. Public Debt of a nation is held by individuals and institutions outside the government Don t want to be put in a position where the choice is between defaulting on their debts and inflating those debts away So what we ve learned so far is that the government should run a budget that is approximately balanced over time but have they actually done so? 4

5 In reality, the US has run a brief surplus after WWII, but it has normally run a deficit ever since. This seems inconsistent with the previous conclusion we made. However, the graph below shows that our continued deficit has not (at least yet) led to default. We use this measure, rather than just looking at the size of the debt because GDP is a good indicator of the potential taxes the government can collect. If the government s debt grows more slowly than GDP, the burden of paying that debt is actually falling compared with the government s potential tax revenue. Key: debt GDP ratio can fall, even when debt is rising, as long as GDP grows faster than debt. Growth and inflation sometimes allow a government that run persistent budget deficits to nevertheless have a declining debt GDP ratio 5

6 Recap: We know that the Fed uses a change in money supply to manipulate the market s equilibrium interest rate. Why would they wand to change the federal funds rate? In order to bring a short run problem (positive or negative output gap) back to potential output. The federal open market committee meets every six weeks to set a target federal funds rate: which is the desired level of the federal funds rate. What is the most common tool the Fed uses to change the FFR? Open market operations. (The other two are not used very often but they did use the discount window in an effort to address the 2008 financial crisis.) 6

7 In 1993, Stanford economist John Taylor suggested that monetary policy should follow a simple rule that takes into account concerns about both the business cycle and inflation. In 2009, a combination of low inflation and a large negative output gap briefly put the Taylor s rule of prediction of the federal funds into negative territory, but since having a negative federal funds rate is impossible, the Fed did the best it could by aggressively cutting rates and the FFR fell almost to zero. Like fiscal policy, it s subject to time lags: it takes time for the Fed to recognize economic problems and time for monetary policy to affect the economy. However, since the Fed moves a lot more quickly than Congress, monetary policy is typically the preferred tool. 7

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9 So if we know that in the long run the only change seen in the change of money supply is aggregate price level, are next question needs to be by how much would price level increase or decrease? The answer is that a change in the money supply leads to a proportional change in the aggregate price level in the long run. For example, if the money supply falls by 25%, the agg. Price level falls by 25% in the long run; if the money supply rises by 50%, the agg. Price level rises 50% in the long run. How do we know this? Suppose that all the prices in the economy doubledand suppose money supply doubles at the same time. What difference does this make to the economy in real terms? None. All real variables in the economy, such as real GDP and real value of money supply are unchanged. So there is no reason for anyone to behave differently to the new price level. This demonstrates the concept of monetary neutrality. Economists argue that money is neutral in the long run. 9

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