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Chapter 30
FISCAL POLICY AND
PUBLIC FINANCE
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
30-2
Today’s lecture will:
• Explain the logic of the Ricardian equivalence
•
•
•
•
theorem.
Distinguish sound finance from functional
finance.
List six assumptions of the AS/AD model that
lead to potential problems with the use of fiscal
policy.
Describe how automatic stabilizers work.
Distinguish the nuanced functional finance view
of fiscal policy from the New Classical view of
fiscal policy.
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Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
30-3
Classical Economics and
Sound Finance
• Sound finance – the government
•
budget should always be balanced
except in wartime.
Ricardian equivalence theorem –
deficits do not affect the level of
output because people increase
savings to pay future taxes to repay
the deficit.
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30-4
Nuanced Sound Finance
• During the Depression of the 1930s
•
economists began to question the
theory of sound finance.
Nuanced sound finance – a policy of
sound finance should be maintained
in a small recession, but a
depression might require deficit
financing.
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30-5
Functional Finance
• Functional finance – governments
•
should make spending and taxing
decisions on the basis of their effect
on the economy.
If spending was too low, government
should run a deficit; if spending was
too high, government should run a
surplus.
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30-6
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.
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30-7
Interest
rate
Offsetting Effects of
Financing the Deficit
S0
AD2AD1
AD0
Price Level
SAS
i1
i0
D1
Net effect
D0
0
McGraw-Hill/Irwin
I0
I1
Quantity of
loanable funds
Y0
Y2 Y1
Partial
crowding out
Real output
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30-8
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.
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30-9
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.
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30-10
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.
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30-11
Size of the Government
Debt Doesn’t Matter
• Although there is no inherent reason why
activist functional finance 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.
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30-12
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.
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30-13
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.
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30-14
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.
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30-15
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.
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30-16
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.
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30-17
Decrease in Fluctuations
in the Economy
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30-18
New Classical Public Finance
• New Classical macroeconomics is a
•
•
theoretical approach to macroeconomics
that revived many pre-Keynesian ideas.
It is centered on the Ricardian equivalence
theorem.
It is criticized because it assumes the
aggregate economy is a single
representative agent and ignores
coordination problems.
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30-19
AD0
AD2AD1
SAS
Price Level
Price Level
The Nuanced Keynesian and
New Classical Views
SAS
P0
AD0
Real output
McGraw-Hill/Irwin
Q0
Real output
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
30-20
Incentive and Supply-Side
Effects of Public Finance
• The Republican party used New
•
•
Classical macroeconomics to justify
tax cuts.
Supply-side economics emphasized
the incentive effects of tax cuts that
would lead to growth.
Tax cuts were designed to prevent
the growth of government spending.
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30-21
Summary
• Sound finance is a view that the
•
government budget should always
be balanced except in wartime.
The Ricardian equivalence theorem
states that it doesn’t matter whether
government is financed by taxes or
deficits; neither would affect the
economy.
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30-22
Summary
•
•
Although proponents of sound finance believed
the logic of the Ricardian equivalence theorem,
they believed deficit spending could affect the
economy. Still, because of political and moral
issues, proponents of sound finance promoted
balanced budgets.
Functional finance is the theoretical proposition
that governments should make spending and
taxing decisions based on their effect on the
economy, not moralistic principles.
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30-23
Summary
• Six assumptions that make functional
finance difficult to implement are:
 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.
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30-24
Summary
• The New Classical view is that the Ricardian
•
•
equivalence theorem is not only theoretically
true, it is also true in practice and, therefore,
government should not use deficit spending.
The nuanced Keynesian view is that deficit
spending can crowd out private investment,
reducing the effect of deficit spending on the
economy, but deficit spending will increase
output in the economy.
New Classicals believe that growth is much
more central to the well-being of individuals.
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30-25
Review Question 30-1 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 30-2 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  2008 by The McGraw-Hill Companies, Inc. All rights reserved.