DYNAMIC POWERPOINT SLIDES BY SOLINA LINDAHL CHAPTER. Fiscal Policy

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1 DYNAMIC POWERPOINT SLIDES BY SOLINA LINDAHL CHAPTER 35 Fiscal Policy

2 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? For applications, click here To Try it! questions To Video

3 Food for Thought. Some good blogs and other sites to get the juices flowing:

4 Fiscal Policy Fiscal Policy: federal government policy on taxes, spending, and borrowing that is designed to influence business fluctuations. I tried a tax cut George, I m gonna go in a different direction. 4

5 Fiscal Policy Two categories of fiscal policy during recession The government spends more money. The government cuts taxes. One goal In either case, the goal: greater spending.

6 Try it! Do you think the government is right to begin massive spending programs during deep recessions? a)yes b)no

7 Fiscal Policy: The Best Case Effect of a decrease in consumer spending growth: This is equivalent to a decrease in velocity, 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. Can fiscal policy help?

8 Fiscal Policy: The Best Case Inflation rate (p) Solow Growth SRAS (Ep = 7%) curve (1) Consumers spending growth 7% a -1% 0% p (2) Govt. spending growth b 6% a b real growth, b a 3% Real GDP growth rate

9 Try it! A decrease in consumption growth will cause the Solow growth curve to a)shift inward. b)shift outward. c)remain unchanged. d)first shift outward and then shift inward. To next Try it!

10 Fiscal Policy: The Best Case Effect of a decrease in consumer spending growth In the long-run wages will adjust and to its normal growth rate. will return The economy will move from b a. The recession will be over. The point of increasing recession sooner. is to end the In the long run we are all dead. J.M. Keynes

11 Take a look.. They re back Keynes vs. Hayek: The Fight of the Century Round 2. Is Fiscal Policy stabilizing or destabilizing? Has the Great Recession proved either man right? (10:10 minutes)

12 Try it! Economists believe that government spending sometimes increases growth for all of these reasons except: a)spending can lower inflation and keep prices and wages steady. b)spending can put all of the factors of production to greater use. c)spending can encourage additional private investment. d)spending can increase consumer confidence. To next Try it!

13 Fiscal Policy: The Best Case The 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.

14 Fiscal Policy: The Best Case Inflation rate (p) Solow Growth SRAS (Ep = 7%) curve 7% a (3) Multiplier AD shifts right even further b 6% -1% 0% Economy in recession at point b: (2) Govt. spending growth, AD shifts right 3% Real GDP growth rate

15 The Limits to Fiscal Policy 1. Crowding out: The increase in AD is reduced or neutralized if government spending reduces private spending. 2. A drop in the bucket: The economy is so large that government can rarely increase spending enough to have a large impact. 3. A matter of timing: It can be difficult to time fiscal policy so that the AD curve shifts at just the right moments. 4. Real shocks: Shifting AD doesn t help much to combat real shocks.

16 The Limits to Fiscal Policy: Crowding Out 1. Crowding Out: Out The decrease in private spending that occurs when government increases spending. Government borrowing can squeeze out private borrowing especially if the pool (of funds) is limited.

17 The Limits to Fiscal Policy: Crowding Out Two forms of Crowding Out 1) Raising Taxes to Finance Fiscal Policy Higher taxes reduce private spending. The greater the fraction of additional income that is spent, the greater will be crowding out. Implication: Fiscal policy will be most effective when people are otherwise afraid to spend their money. 17

18 The Limits to Fiscal Policy: Crowding Out 2) Selling 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 effective when the private sector is reluctant to save or invest. Private spending will be less sensitive to changes in interest rates.

19 Try it! Crowding out occurs when: I. the government borrows money from the public that firms would have used for investment funds. II. the government sells bonds, raising interest rates and causing people to save more and consume less. III. an economy is closed and does not trade with the outside world. a)i only b)i and II only c)ii and III only d)i, II, and III To next Try it!

20 The Limits to Fiscal Policy: Crowding Out Tax Rebates and Tax Cuts 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.

21 The Limits to Fiscal Policy: Crowding Out A Special Case: Ricardian Equivalence Ricardian Equivalence occurs when people see that lower taxes today mean higher taxes later. They save their tax cut to pay future taxes. Ricardian equivalence describes some people but not all. How many of us systematically save tax cuts to prepare for future government austerity? To the extent that this occurs, bond-financed tax cuts are less effective in the short-run.

22 Try it! When consumers save their tax cut for an assumed future tax increase they are adhering to: a)the bandwagon effect. b)intertemporal substitution. c)the multiplier effect. d)ricardian equivalence. To next Try it!

23 The Limits to Fiscal Policy: The Paths of Crowding Out

24 The Limits to Fiscal Policy: A Drop in the Bucket 2. A Drop in the Bucket Normally changes in fiscal policy in terms of percentage of GDP are small. Most of the non-security discretionary spending is less than 20% of the federal budget. Stimulus plan passed under President Obama in 2009 largest since WWII. Spread over 3-4 years. At its peak, it was only about 2% of annual GDP. September 2010: Unemployment rate still high (9.6%)

25 The Limits to Fiscal Policy: A Matter of Timing 3. A Matter of Timing Fiscal policy is intended to correct short-term problems. By the time fiscal policy is in place, economic conditions have often changed. Relevant lags: Recognition Problem must be recognized. Legislative Congress must propose and pass a plan. Implementation Bureaucracies must implement the plan. Effectiveness The plan takes time to work. Evaluation and Adjustment Did the plan work? Have conditions changed?

26 The Limits to Fiscal Policy: A Matter of Timing 3. A Matter of Timing Monetary policy is also subject to lags, but: Generally shorter than for fiscal policy. Federal Reserve can act very quickly. The day after 9/11 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.

27 The Limits to Fiscal Policy: A Matter of Timing Automatic Stabilizers: Stabilizers changes in fiscal policy that stimulate AD in a recession without explicit action by policy makers. Welfare and transfer programs In a recession more people apply for welfare assistance and unemployment benefits, increasing income, consumption and therefore AD. Consumption smoothing People drawing on savings during an economic downturn. Credit cards can help consumption smoothing.

28 Automatic Stabilizers Food Stamps are an automatic stabilizer. More Americans are using food stamps, but it varies by state. Click here for the WSJ interactive map. (Map represents September 2011 usage)

29 The Limits to Fiscal Policy Government Spending versus Tax Cuts as Expansionary Fiscal Policy Differences are political as well as economic 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 a more certain influence on the economy, but is slower. Tax cuts will increase spending only if people don t save their new money.

30 Try it! In general, do you believe tax cuts or spending increases are preferable if the government decides to stimulate the economy? a)tax cuts b)spending increases To next Try it!

31 The Limits to Fiscal Policy The Obama Stimulus plan: Success or failure? The American Recovery and Reinvestment Act: $292 billion in federal tax cuts $272 billion in direct federal spending $223 billion in grants to the governments of the fifty states. The consensus? Many of the tax cuts were saved or went to pay down debt. (doesn t re-employ many workers) Grants to states prevented state layoffs. (but made states more dependent on federal revenues) Expenditures covered a wide range of projects. (perhaps not targeted towards the unemployed sectors enough) Crowding out? No. Interest rates remained very low.

32 The Limits to Fiscal Policy: Real Shocks 4. Real Shocks 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. Because the economy is at full employment most of the increase in will crowd out private spending. Most of the effect shows up as p.

33 Limits to Fiscal Policy: Effect of Real Shock New Solow growth curve Inflation rate (p) c 16% 8% Old Solow growth curve b New SRAS (1) Real shock (1) Solow growth curve shifts left: p SRAS shifts up Old SRAS real growth rate recession: a b (2) AD Result: Even higher p ; Slightly higher growth: b c a Real GDP growth rate -3% -1% 3%

34 Try it! When the government lowers its spending growth so that the AD curve shifts from AD1 to AD2, the multiplier effect will cause the AD curve to: a)shift to back to AD1. b)remain at AD2. c)shift to further to AD3. d)shift to all the way back to AD4.

35 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. But: Governments usually operate like this Increase spending in bad times. Increase spending in good times. Result: Rising debt

36 When Fiscal Policy Might Make Matters Worse When the debt is large, interest payments on become a large fraction of the budget. In extreme situations, additional government borrowing can lead to economic collapse. Example: Argentina, Greece, Thailand, Mexico, Indonesia. And many more. Government debt rose to compared to GDP. Countries are in danger of defaulting on their debt. Drives investment away from these countries, and causes all sorts of larger ramifications.

37 When Is Fiscal Policy a Good Idea? Summary: Fiscal Policy is best: 1.When the economy needs a short-run boost, even at the expense of the long run 2.When the problem is a deficiency in aggregate demand rather than a real shock 3.When many resources are unemployed