Worth Publishers, Do Not Duplicate, Do Not Circulate. Fiscal Policy. Facts and Tools MODERN PRINCIPLES: MACROECONOMICS MODERN PRINCIPLES OF ECONOMICS

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1 MODERN PRINCIPLES: MACROECONOMICS Fiscal Policy Facts and Tools 1. What shifts AD to the left: A rise in taxes or a cut in taxes? Does this push v! up or push it down? 1. A tax increase; this pushes v! down. 2. Let s see what the three difficulties with using fiscal policy look like in real life. Categorize each of the three stories below as either 1. Crowding out, 2. A drop in the bucket, 3. A matter of timing a. During a recession, the State of New York hires 1,000 new trash collectors.the state legislature in Albany takes six months to pass a law to hire the new trash collectors, and because of government rules and paperwork, the government actually hires the workers 18 months after the recession has begun. b. During a recession, the State of New York hires 1,000 new trash collectors. Five hundred of the new trash collectors, however, were just people who quit their jobs as restaurant employees in order to take the better-paying trash collector jobs. c. During a recession, the State of New York hires 1,000 new trash collectors. However, during the course of the recession, 300,000 additional people in New York lose their jobs. 2. a. 3: A matter of timing b. 1: Crowding out c. 2: A drop in the bucket 3. When people buy government bonds, are they borrowing money or saving money? 3. Saving money MODERN PRINCIPLES OF ECONOMICS 4. Imagine you live in the land of Ricardia, where every citizen is a Ricardian and thus Ricardian equivalence is 100 percent true. Government spending never changes in Ricardia: It s a fixed amount every year.thus, when the Ricardian government cuts taxes, it has to pay for the government spending by borrowing more money and raising future taxes to repay the debt. a. When Ricardian income taxes are cut, what will Ricardian citizens do with the extra money in their paycheck: Will they spend all of it, save all of it, or spend some and save the rest? b. Suppose that instead of a tax cut, the Ricardian government just sends citizens rebate checks. What will Ricardian citizens do with the extra money from these rebate checks: Will they spend all of it, save all of it, or spend some and save the rest? S-153

2 S-154 CHAPTER 17 Fiscal Policy 4. In both cases, Ricardian citizens will save all of a tax cut or rebate check. 5. It s often very difficult to get the timing of fiscal policy right. In this chapter, we listed five relevant lags. a. If each of the lags lasts three months, is the total lag longer or shorter than the typical recession since World War II? Data on the length of recessions is here: Look at the bottom of the column titled Contraction. b. Of the five lags, the last one only involves watching how things turned out. If there are only four important lags, and they last three months each, will the average recession last longer than the average fiscal policy lag? 5. a. The 15 months of lags is longer than the average recession.the average recession since 1945 has lasted 10 months (as of the date of publication), while five lags would eat up 15 months. b. Again, the recession will be shorter than the fiscal policy lags. 6. You re flipping through the newspaper, reading about shocks that have hit the U.S. economy and reading what Congress is planning to do about the shocks. (Remember that shocks can be either good or bad.) Is Congress even getting the direction of its response right? And if it is getting the basic direction correct, is it fighting against a Solow growth shock, where a fiscal response may not be very effective? While these policy choices will each have effects on long-run growth and on income distribution, in this chapter you should only focus on the big picture effect on aggregate demand. Fit each of the following cases into one of three categories: 1. Wrong direction 2. Correct direction for an AD shock 3. Correct direction for a Solow growth shock, but expect a big change in inflation a. Many banks have failed, and the money supply has fallen. In response, Congress decides to raise income taxes to pay down the federal debt. (Historical note: This policy response was similar to FDR s campaign platform when he ran for president in 1932.) b. Many banks have failed, and the money supply has fallen. In response, Congress decides to cut back on government purchases to save money. c. A wave of investor euphoria ( irrational exuberance ) about the Internet has increased spending growth. Congress raises income taxes on the richest Americans in response. d. Oil prices double over the course of a year, from $2 per gallon to $4 per gallon. In response, Congress sends $300 checks to every American family so that people can better afford to pay for gas. e. Oil prices double over the course of a year, from $2 per gallon to $4 per gallon. In response, Congress raises taxes on companies that refine and deliver petroleum products. f. The Federal Reserve has followed a slow-money-growth policy, despite the wishes of Congress. In response, Congress cuts taxes and increases government purchases. 6. a. Wrong direction b. Wrong direction c. Correct direction for an AD shock d. Correct direction for a Solow growth shock, but expect a big change in inflation e. Wrong direction f. Correct direction for an AD shock

3 7. Which of the following is an automatic stabilizer in the U.S. economy? There may be more than one: a. Consumers usually spend some of their savings and eat food from the pantry during recessions. b. Business owners usually purchase more capital equipment whenever profits fall. c. Governments automatically transfer cash to the unemployed when the economy is weak. d. When Americans have less demand for U.S. manufactured products, foreigners might pick up some of the slack, buying these unsold U.S.- made goods. 7. All of the above would be automatic stabilizers, if they occurred. Note that in reality part b doesn t happen: Investment usually falls when profits fall.and in practice, d is a weak mechanism. So a and c are strong, real-world stabilizers. 8. Why was the Great Depression an especially appropriate time to use fiscal policy rather than just monetary policy alone? 8. The recession was so deep and there were many unemployed machines and workers.therefore, there was less risk of crowding out of machines and workers that would have been used anyway. 9. U.S. net government debt is about 37 percent of GDP. If it rose to 100 percent of GDP, and the interest rate on the debt were 5 percent (not far from the truth at present), then what fraction of U.S. GDP would go toward paying interest on the debt? (Note:After World War II,U.S. debt was greater than 100 percent of GDP.) 9. 5 percent of GDP would go toward paying the debt. 10. Which kind of aggregate demand shift has fewer lags: changes in monetary policy or changes in fiscal policy? 10. Monetary policy has fewer lags, especially on the political side.with monetary policy, all it takes is a conference call among the members of the Federal Open Market Committee to cut interest rates. Thinking and Problem Solving 1. a. In the chapter, we wrote that Tyler does not save and plan according to the theory of Ricardian equivalence but Alex is more of a Ricardian. In light of this, who probably cuts back their spending the most when their taxes temporarily rise: someone like Tyler who is not Ricardian or someone like Alex who is? b. If the U.S. government wants to use fiscal policy to shift AD around easily, which one would the U.S. government prefer to make more copies of: Tyler or Alex? 1. a. Tyler likely changes his spending the most in response to temporary tax rates. b. More Tylers are a good thing if the government wants to shift AD around easily. More Alexes means a more stable AD curve, at least as far as short-term tax policy is involved. 2. Using the figure below, suppose that a change in fiscal policy shifts AD from AD(1) to AD(2).Which response below would be most likely to cause that shift? Choose one of a, b, c, or d. a. A rise in taxes OR a rise in government spending b. A rise in taxes OR a fall in government spending c. A fall in taxes OR a rise in government spending d. A fall in taxes OR a fall in government spending Fiscal Policy CHAPTER 17 S-155

4 S-156 CHAPTER 17 Fiscal Policy Inflation rate ( ) 2. c. A fall in taxes OR a rise in government spending 3. Consider the figure below. Suppose that there s a rise in v! due to business optimism what Keynes called the animal spirits of investors.this pushes us to AD(2). If the government s goal is to keep output close to the Solow growth rate, and if fiscal policy is the tool that the government wants to use, what should it do? Choose one of a, b, c, or d. a. A rise in taxes OR a rise in government spending b. A rise in taxes OR a fall in government spending c. A fall in taxes OR a rise in government spending d. A fall in taxes OR a fall in government spending Inflation rate ( ) Solow growth rate Solow growth rate 3. b. A rise in taxes OR a fall in government spending 4. Consider the following imaginary newspaper quote, the type that you often read when Congress passes a tax rebate during a recession: Many Americans report that they will put the tax rebate straight into their savings accounts or use it to pay off credit cards that they maxed out during the recent economic boom. If Congress is trying to shift AD to the right, are these kinds of quotes good news or bad news from Congress s point of view? 4. Bad news: This is evidence of crowding out or partial Ricardian equivalence. 5. Which of the following government policies are automatic stabilizers for the economy? Unemployment insurance AD (1) AD (1) SRAS Real GDP growth rate SRAS AD (2) Real GDP growth rate Temporary tax cuts that Congress passes when bad economic news hits Temporary spending increases that Congress passes when bad economic news hits 5. The first is automatic: American workers get unemployment insurance payments as soon as they apply, whether the economy is good or bad.the other two options require Congress to pass a special law, which takes time. AD (2)

5 6. a. Which policy is likely to shift aggregate demand more? In which direction will it shift? A tax increase that occurs in the same year as a spending increase A tax increase that occurs without a spending increase b. Why is this so? 6. a. The second will have a bigger impact, and it will shift AD downward, to the left. b. The spending increase stimulates aggregate demand, while the tax increase weakens it. If the spending increase were included, it would soften (and perhaps reverse) the effect of the tax increase. 7. Ricardian equivalence is the idea that people might just use the extra money from their tax cuts to buy the very government bonds that pay for the tax cut. Let s think about the opposite situation: If Ricardian equivalence is true, and the government raises taxes (holding spending constant), how does the average person s behavior change? In other words, how do they react to a tax increase? 7. If taxes rise in a world where Ricardian equivalence is true, people will either dip into their savings or just borrow money to keep consuming just as much as before. When taxes are lower in the future, people will pay off these debts. Think of it this way: Suppose that your income is $10 this period and $6 next period and the government takes $2 in taxes each period. If you do nothing, your consumption path is $8 this period and $4 next period. But suppose that you want to smooth your consumption path (as we discussed in Chapter 8). No problem.you can save $2 (assume a 0 percent interest rate for simplicity), which means you consume $6 this period and $6 next period. Now the government changes its tax scheme so you pay $0 this period and $4 next period. If you do nothing, you will consume $10 this period and $2 next period, which is not your most preferred consumption path. No problem. Save $4. Now you are back to $6 and $6. Okay, what about if the government changes taxes to $4 and $0? Again, no problem. Don t save anything and once again, you will consume $6 this period and $6 next period your most preferable consumption path.thus, by adjusting consumption and saving decisions, you can always restore your desired consumption path as the government changes when it taxes this is the essence of Ricardian equivalence. 8. Again, think about the extreme case of crowding out known as Ricardian equivalence. In real life, few citizens buy or sell government bonds directly: Instead, normal people put their money in a bank (or invest it in a mutual fund), and then their bank (or mutual fund) uses that money to buy government bonds. a. So does a tax cut mean banks will get more deposits, fewer deposits, or can t you tell with the information given? b. How will the average bank s behavior change as a result of this tax cut, taking your response to part a into account? 8. a. A tax cut means banks get more deposits. b. The average bank will use those deposits to buy the extra government bonds so the tax cut gets indirectly used to pay for the extra deficit. 9. We discussed three situations where fiscal policy is most likely to matter (though fiscal policy is best when all three are true): 1. When the economy needs a short-run boost. 2. When the problem is low AD, not low Solow growth. 3. When many machines and workers are unemployed. Fiscal Policy CHAPTER 17 S-157

6 S-158 CHAPTER 17 Fiscal Policy Let s fit each of the following news stories into one (or more) of the above categories. a. World War II ends, and millions of U.S. soldiers return home. (Note: As a matter of history, returning WWII soldiers were overwhelmingly employed by the private sector.) b. Consumption spending declines dramatically as people fear a recession. c. Foreigners decide they are unwilling to buy U.S.-made airplanes because of rumors they read on the Internet. 9. a. When many machines and workers are unemployed. b. When the problem is low AD, not low Solow growth. c. When the economy needs a short-run boost. 10. Fiscal policy cannot cure all ills. Sometimes: X. The economy needs a long-run boost. Y. The problem isn t low AD, but low Solow growth. Z. Almost all machines and workers are employed; they re just not very productive. Sort the following cases into either fiscal solution possible or productivity problem. a. American wages have grown slowly for many years. b. Peasants in the Middle Ages are using primitive tools to produce food. c. Peasants in the Middle Ages suffer from a drought that hurts the season s crops. d. American workers get laid off by the hundreds of thousands because of a rapid collapse in investment purchases. e. Schools are doing a bad job teaching students, so students become ineffective employees. f. High taxes on investment discourage people from saving and building up the capital stock for future workers to use. g. High taxes on investment discourage businesses from purchasing investment goods. 10. Productivity problem: a, b, c, e, f. Fiscal solution possible: d, g. Note that the difference between f & g is just in emphasis: f focuses on the long run effect of high investment taxes, while g focuses on the short-run effect. Challenge 1. When we discussed unemployment in Chapter 10, we noted that people will search a long time to find a good job. So it might only take you two weeks to find a minimum wage job, but it might take you six months to find a job paying five times the minimum wage. Let s investigate how this simple fact might cause expansionary fiscal policy to increase the unemployment rate, at least temporarily. In the United States, federal contracts to build roads, bridges, or buildings must pay higher-than-average wages.the law requiring this is known as the Davis-Bacon Act, or the prevailing wage law. a. If the unemployment rate is 6 percent before a rise in government purchases, and if a rise in government purchases induces the typical unemployed person to search 10 percent longer in the hopes of finding a high-paying government job, what will the value of the unemployment rate be after the rise in government purchases? Only consider the impact of this waiting-for-a-good-job effect.

7 b. If the government wanted to get the good aggregate-demand stimulating effects of fiscal policy, but wanted to eliminate this extra waiting-for-a-good-job unemployment, how could it change current law to do so? 1. a. By searching 10 percent longer, this raises the unemployment rate by 10 percent above its starting value. If the starting value was 6 percent, then the extra waiting would raise the unemployment rate by percent, or 0.6 percent.thus, this policy will raise the unemployment rate to 6.6 percent. b. The government could change the law so that government contracts only paid the average wage for workers: Then they wouldn t wait 10 percent longer in hopes of getting a better job. Unemployment would only be 6 percent instead of 6.6 percent. 2. Nobel Laureate Amartya Sen has pointed out that one way to prevent starvation during droughts in the poorest countries is to just pay peasants to build roads, sewer lines, and other public goods during these droughts. In the poorest countries, these peasants have no savings accounts, and almost no way to borrow money. In rich countries by contrast, most people have savings accounts and credit cards. a. Is the poor-country multiplier probably bigger or smaller than the rich-country multiplier, based on these facts? b. All countries get hit by shocks, but not all countries have the same automatic stabilizers. Based on these facts, which countries probably have smoother GDP growth: Poor countries or rich countries? (Note: The answer that is true in theory is also true in practice, a point emphasized in a 1995 paper in the American Economic Review by Garey and Valerie Ramey, Cross Country Evidence on the Link between Volatility and Growth. ) 2. a. Poor countries probably have bigger multipliers, because every bad shock to the economy makes it much harder for poor people to buy consumer goods, while every good shock makes it easier for poor people to buy consumer goods. b. Poor countries have more volatile GDP growth: Their ups and downs are much larger.a large literature growing out of the Ramey and Ramey paper has confirmed this result. 3. If the U.S. government wanted to, it could just say that everyone who gets an unemployment insurance check is employed in searching for a job, and the government could claim that these government employees are producing job search services. Recall that in the official definition of GDP, government purchases (G), do not include transfer payments like unemployment checks and Social Security. a. Would this change in the definition of GDP increase GDP? Would it improve well-being? b. If the government permanently defined unemployed people as employed in job search, then over the course of a few decades as the economy fluctuated, would GDP look more volatile or less volatile than it does under the regular definition? (Hint: You might find it easier to answer if you consider GDP from the factor income perspective.) 3. a. Yes, it would raise measured GDP but it would not increase well-being. It s just an accounting change. b. GDP would probably be less volatile: During bad times, unemployed people would show up as shifting from private sector work to government work, and during good times, these government workers would shift back to the private sector column. Once again, however, well-being would not change. Fiscal Policy CHAPTER 17 S-159

8 S-160 CHAPTER 17 Fiscal Policy 4. We usually think about crowding out as a decrease in private consumption or investment in response to an increase in government purchases. But the idea works in reverse as well, an idea we might call crowding in. Consider the economy below. a. Starting from this initial position, the economy is hit by one shock: A large decrease in government purchases, perhaps caused by the end of a war. Holding the growth of C, I, and X constant for a moment, illustrate this shock below, labeling the change Fall in growth of G. b. Now consider a possible side effect of the fall in the growth of G: the reversal of crowding out or crowding in. If there is 100 percent crowding in what happens to the AD shift you described in part a? c. If there were 100 percent crowding out/in and no multiplier effect, what can we say about the effect of a change in the growth of G on aggregate demand? d. Consider all of the laid-off government workers in this question: If there were 100 percent crowding out/in and no multiplier effect, where do these laid-off workers end up? 4. a. Inflation rate ( ) 4% Solow growth curve 4% SRAS ( e = 4%) AD (M + v = 8%) Fall in growth of G Real GDP growth rate b. With 100 percent crowding out the decrease in G is matched by an increase in private consumption and investment spending, which returns us to the original AD curve. c. If there is 100 percent crowding out/in and no multiplier, then any change in the growth of G has absolutely no impact on aggregate demand. d. All of the laid-off government workers immediately get jobs making consumer goods, investment goods or exports.after World War II, there was a large decrease in government purchases and many people feared a mass recession but the economy did in fact begin to grow almost immediately. 5. According to recent estimates by Susan Woodward and Robert Hall, an extra dollar of government purchases raises GDP by an extra dollar so there is little evidence for a multiplier effect in the short run, but also little evidence for crowding out in the short run. (Perhaps both effects are at work, but they just happen to balance out in practice.) Let s use these estimates as a rule of thumb to solve the following economic puzzles: a. U.S. GDP is about $14 trillion. In a typical recession, GDP is about 2 percent below the Solow growth rate. If Congress wants to return GDP to the Solow growth rate by increasing government purchases, how big a rise in government purchases should it enact? Give your answer in dollars.

9 b. Canadian GDP is about $1.2 trillion (U.S. dollars). If Canadian GDP is 3 percent above its Solow growth rate, and the Canadian Parliament wants to change government purchases to return to the Solow growth rate, what change in government purchases should it enact, measured in U.S. dollars? c. How do your answers to parts a and b change if there s stronger crowding out, and the multiplier falls to 0.5? (In other words, a rise in G of $1 raises GDP by only $0.50.) Answer in U.S. dollars. d. How do your answers to parts a and b change if there s a bigger multiplier effect on consumer spending, and the multiplier rises to 2? (In other words, a rise in G of $1 raises GDP by $2.) Answer in U.S. dollars. 5. a. Increase of $280 billion. b. Decrease of $36 billion. c. Increase of $560 billion and decrease of $72 billion, respectively. (Note that with a smaller multiplier effect you need a bigger change in spending growth to cause the same AD shift.) d. Increase of $140 billion and decrease of $18 billion, respectively. Fiscal Policy CHAPTER 17 S-161

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