LECTURE NOTES. Chapter 18: Fiscal Policy. 1. The Goals of Macroeconomic Policy METROPOLITAN STATE UNIVERSITY OF DENVER INTERMEDIATE MACROECONOMICS

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1 LECTURE NOTES Chapter 18: Fiscal Plicy 1. The Gals f Macrecnmic Plicy Macrecnmic plicy Mnetary Plicy: The Federal Reserve Fiscal Plicy: The Treasury Gals: (1) lw unemplyment, (2) price stability, (3) ecnmic grwth Ecnmic grwth: T ptential utput, r t increase ptential utput. Can plicy achieve the secnd? (Wait fr chapter 20) Fiscal and mnetary plicy need t crdinate. Different than ne (mnetary plicy) being ruled by the ther (fiscal plicy) Assume the plicymaker minimizes the fllwing lss functin f unemplyment, inflatin, and utput grwth as deviatins frm the target (*) levels: ( ) ( ) Page 1 f 7

2 2. The Gals f Macrecnmic Plicymakers Plicymaking analysis needs t be realistic Public-chice Partisan thery Public chice Plicy makers are nt angels, but nrmal peple with persnal preferences D plicy analysis withut rmance Public chice is the micrecnmic applicatin t plicy Plicymakers maximize their wn welfare, nt the scial welfare Fr the plicymaker, the lss functin is a functin f vtes lst ( ) Then: ( ) ( ) are the lss f vtes by deviating frm respective targets is the lss f vtes due t ther influences (freign plicy, dmestic issues, etc.) The plicymaker minimizes his lss functin, but wuld that minimize the scial lss functin? Yes if there is cllective ratinality Vters understand hw ecnmics wrk Vters knw hw t track plicy t utcmes efficiently Vters d nt frget Deviatins frm cllective ratinality Vters are mypic: Vters are influenced by the ecnmy f the last few quarters and are mre cncerned with utput than inflatin. (1) Plicy that takes a lng time t have an ecnmic effect might be ignred and (2) plicymakers will try t bm the ecnmy (plitical business cycle) Unemplyment is mre likely t result in lss than inflatin: Incumbent plicymaker will try t play the Phillips curve t win the electin A deficit bias exists in the budget prcess: (1) Plicymakers prefer t spend mney than t tax it away frm vters. (2) Prmise a plicy that smene else is ging t pay. Ratinal irratinality: Vters have utility in hlding a psitin, nt in being right (i.e. tariffs t internatinal trade, minimum wages, etc.) Page 2 f 7

3 The Partisan Thery Plicymakers are idelgically mtivated leaders f cmpeting parties Each party represents cnstituents with different idelgies There is party-cycle, rather than a business cycle Assume a liberal party and a cnservative party If liberal party wins, gvernment spending increases (AD increases) Inflatin increases Next electin cnservative party win Spending becmes mre restrictive (AD falls) Next electin liberal party wins And s n The Fur Stages f Ppulism (Drnbusch and Edwards, 1990) Stage 1: A ppulist party assumes pwer and his plicies seem t yield gd results Stage 2: Bttleneck effects start t appear (n mre utput gap, t much cnsumptin at the expense f investment). Fiscal deficit rises. Because the gvernment impses price cntrls, the undergrund ecnmy grws Stage 3: Inflatin accelerates. Fiscal revenue falls in real terms. Real wages fall. The failure f the ppulist plicy is nw evident Stage 4: A new gvernment puts frward an rthdx refrm (prbably with the endrsement f sme internatinal rganizatin like the IMF that wuld lan the funds the cuntry has cnsumed). The refrms include price deregulatin, and then a fall in real wages. Cntinue Stage 5: The rthdx gvernment lses the electin. Stage 6: The ppulist gvernment blames the rthdx gvernment fr the crisis, his plicies seem t yield gd results because its incnsistency is cncealed behind the recvery f the crisis prduced by the previus ppulist gvernment Mre Public Chice Develpments Rent Seeking: Spend resurces t capture a larger share f a given wealth withut creating mre wealth Regulatry capture: A regulatr agency advances the interest f the regulated grup (which captures the regulatry agency) Entanglement thery: Business and gvernment sectrs are intercnnected bdies that develp numerus relatinships t serve their jint interests Page 3 f 7

4 3. The Federal Budget Gvernment spending Tax cllectins Usually represented in nminal (nt real) values in terms f NGDP Deficit = T G Deficit/NGDP = Cnslidated budget: spending and tax cllectin at all gvernment levels Macrecnmic stability relies n the cnslidated budget. This requires a crdinatin between the federal gvernment, states, and all levels f gvernments that manage a budget Page 4 f 7

5 4. The Ecnmy and the Federal Budget: The Cncept f Autmatic Fiscal Stabilizers Three variables that affect macrecnmic gals in the budget: (1) purchases f (new) gds and services (2) transfers (3) taxes Keynesian prescriptin: Can be managed autmatically (at least t sme extent)? Autmatic fiscal stabilizers: Changes in taxes and transfers that ccur with the level f incme changes Taxes If, then equals the average tax rate: ( ) If, then is larger than the average tax rate ( ) allws fr tax prgressivity and transfers because smene is paying mre than the average tax rate in the margin is the marginal tax rate ( ) If fllws that with increase (decrease) in incme tax receipts increase (decrease) If the ecnmy grws the deficit falls (the expansin dampens) IF the ecnmy falls, the deficit increases (the fall is reduced) Transfers When utput increase unemplyment decreases and s des unemplyment benefits When utput decreases unemplyment increase and s des unemplyment benefits Recall Replace the abve tax frmula int the Keynesian cnsumptin functin Substitute in the equilibrium cnditin Then Because the marginal tax rate increase r decreases with incme, the multiplier mves inversely with incme smthing the business cycle Page 5 f 7

6 This is the analgus t Page 6 f 7

7 5. Fiscal Plicy Cntrversies: Frm the Reagan Years t the Present The Prs and Cns f Fiscal Plicy Rules A fiscal rule can help t limit deficit accumulatin and therefre inflatin and high debt Keynesians ppse t fiscal rules fr similar reasns they ppse t mnetary plicy rules A rule wuld limit the rle f autmatic fiscal stabilizers A rule wuld limit the pssibility f discretinary cuntercyclical fiscal actins What Abut the Deficit? Cyclical deficits: Prtin f the federal deficit that result frm the ecnmy s business cycle Structural deficits: Prtin f the federal deficit that wuld exist even if the ecnmy were at its ptential level f utput Lng-term stability requires a structural balanced fiscal budget; the cyclical deficit and surplus cancel ut Page 7 f 7