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FISCAL POLICY
CHAPTER 9
Tuesday, November 22, 11
FISCAL POLICY
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Tuesday, November 22, 11
FISCAL POLICY
• Fiscal Policy is the purposeful movement in
government spending or tax policy designed
to direct an economy
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Tuesday, November 22, 11
FISCAL POLICY
• Fiscal Policy is the purposeful movement in
government spending or tax policy designed
to direct an economy
• Discretionary Fiscal Policy: government
spending and tax changes enacted at the
time of the problem to alter the economy
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Tuesday, November 22, 11
FISCAL POLICY
• Fiscal Policy is the purposeful movement in
government spending or tax policy designed
to direct an economy
• Discretionary Fiscal Policy: government
spending and tax changes enacted at the
time of the problem to alter the economy
• Nondiscretionary Fiscal Policy: that set of
policies that are built into the system to stabilize
the economy (sometimes called automatic
stabilizers)
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Tuesday, November 22, 11
SMOOTHING GDP
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Tuesday, November 22, 11
SMOOTHING GDP
• People would prefer to have smoother consumption than
lumpier (obviously would rather have 3 meals every day
then 6 meals per day in November and no food in
December)
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Tuesday, November 22, 11
SMOOTHING GDP
• People would prefer to have smoother consumption than
lumpier (obviously would rather have 3 meals every day
then 6 meals per day in November and no food in
December)
• For that reasons we don’t like recessions very much-even
if temporary they hurt at the time
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Tuesday, November 22, 11
SMOOTHING GDP
• People would prefer to have smoother consumption than
lumpier (obviously would rather have 3 meals every day
then 6 meals per day in November and no food in
December)
• For that reasons we don’t like recessions very much-even
if temporary they hurt at the time
• Fiscal policy is one way of smoothing things-we try to
provide some insurance during recessions so that things
are better during a recession (and then presumably a bit
worse during booms)
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Tuesday, November 22, 11
HOW NONDISCRETIONARY
FISCAL POLICY WORKS
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Tuesday, November 22, 11
HOW NONDISCRETIONARY
FISCAL POLICY WORKS
• Nondiscretionary fiscal policy consists of policies that are
built into the system so that an expansionary or
contractionary stimulus can be given automatically.
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Tuesday, November 22, 11
HOW NONDISCRETIONARY
FISCAL POLICY WORKS
• Nondiscretionary fiscal policy consists of policies that are
built into the system so that an expansionary or
contractionary stimulus can be given automatically.
• Unemployment insurance, the progressive income tax,
and welfare serve as the built-in policies.
• If the economy is in recession, those who lose their jobs
are granted unemployment and/or welfare benefits
and they owe less in taxes.
• If the economy is growing at an unsustainable rate,
people are making a lot of money and are faced with
higher tax rates and there are fewer people eligible for
government benefits.
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Tuesday, November 22, 11
HOW DISCRETIONARY FISCAL POLICY
WORKS
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Tuesday, November 22, 11
HOW DISCRETIONARY FISCAL POLICY
WORKS
• If we are in a recession the fiscal policy to
stimulate the economy would consist of
• Government buying Stuff
• Government paying people to do stuff
• Decrease in taxes
• Giving money directly to people
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Tuesday, November 22, 11
HOW DISCRETIONARY FISCAL POLICY
WORKS
• If we are in a recession the fiscal policy to
stimulate the economy would consist of
• Government buying Stuff
• Government paying people to do stuff
• Decrease in taxes
• Giving money directly to people
• If we are in an inflationary period the fiscal
policy to contract the economy would
consist of just the opposite (I will focus on
the first one since it is more relevant)
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Tuesday, November 22, 11
EXPANSIONARY FISCAL POLICY I
Price
Index
Real GDP
Tuesday, November 22, 11
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EXPANSIONARY FISCAL POLICY I
Price
Index
Real GDP
Tuesday, November 22, 11
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EXPANSIONARY FISCAL POLICY I
Price
Index
Real GDP
Tuesday, November 22, 11
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SHOCKS
• A Shock is any unanticipated economic
event.
– Aggregate Demand Shock: an unexpected
event which causes aggregate demand to
increase or decrease, e.g. the Sept 11, 2001
terrorist attacks.
– Aggregate Supply Shock: an unexpected
event which causes aggregate supply to
increase or decrease, e.g. Iraq’s 1990 invasion
of Kuwait and threat to Saudi Arabia.
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Tuesday, November 22, 11
EXPANSIONARY FISCAL POLICY IN
RESPONSE TO A DEMAND SHOCK
Price
Index
Real GDP
Tuesday, November 22, 11
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EXPANSIONARY FISCAL POLICY IN
RESPONSE TO A DEMAND SHOCK
We start out here
Price
Index
Real GDP
Tuesday, November 22, 11
8
EXPANSIONARY FISCAL POLICY IN
RESPONSE TO A DEMAND SHOCK
Then get hit by an
aggregate demand
shock
Price
Index
Real GDP
Tuesday, November 22, 11
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EXPANSIONARY FISCAL POLICY IN
RESPONSE TO A DEMAND SHOCK
Then get hit by an
aggregate demand
shock
Price
Index
Real GDP
Tuesday, November 22, 11
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EXPANSIONARY FISCAL POLICY IN
RESPONSE TO A DEMAND SHOCK
Price
Index
The Nondiscretionary
fiscal policy undoes some
of it
Real GDP
Tuesday, November 22, 11
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EXPANSIONARY FISCAL POLICY IN
RESPONSE TO A DEMAND SHOCK
Price
Index
The Nondiscretionary
fiscal policy undoes some
of it
Real GDP
Tuesday, November 22, 11
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EXPANSIONARY FISCAL POLICY IN
RESPONSE TO A DEMAND SHOCK
Price
Index
The Discretionary
policy takes it up
further
Real GDP
Tuesday, November 22, 11
8
EXPANSIONARY FISCAL POLICY IN
RESPONSE TO A DEMAND SHOCK
Price
Index
The Discretionary
policy takes it up
further
Real GDP
Tuesday, November 22, 11
8
EXPANSIONARY FISCAL POLICY IN
RESPONSE TO A DEMAND SHOCK
Price
Index
The Discretionary
policy takes it up
further
Real GDP
Tuesday, November 22, 11
8
EXPANSIONARY FISCAL POLICY IN
RESPONSE TO A SUPPLY SHOCK
Price
Index
Real GDP
Tuesday, November 22, 11
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EXPANSIONARY FISCAL POLICY IN
RESPONSE TO A SUPPLY SHOCK
We start out here
Price
Index
Real GDP
Tuesday, November 22, 11
9
EXPANSIONARY FISCAL POLICY IN
RESPONSE TO A SUPPLY SHOCK
Then get hit by an
aggregate supply shock
Price
Index
Real GDP
Tuesday, November 22, 11
9
EXPANSIONARY FISCAL POLICY IN
RESPONSE TO A SUPPLY SHOCK
Then get hit by an
aggregate supply shock
Price
Index
Real GDP
Tuesday, November 22, 11
9
EXPANSIONARY FISCAL POLICY IN
RESPONSE TO A SUPPLY SHOCK
Price
Index
The Nondiscretionary
fiscal policy undoes some
of it
Real GDP
Tuesday, November 22, 11
9
EXPANSIONARY FISCAL POLICY IN
RESPONSE TO A SUPPLY SHOCK
Price
Index
The Nondiscretionary
fiscal policy undoes some
of it
Real GDP
Tuesday, November 22, 11
9
EXPANSIONARY FISCAL POLICY IN
RESPONSE TO A SUPPLY SHOCK
Price
Index
The Discretionary
policy takes it up
further
Real GDP
Tuesday, November 22, 11
9
EXPANSIONARY FISCAL POLICY IN
RESPONSE TO A SUPPLY SHOCK
Price
Index
The Discretionary
policy takes it up
further
Real GDP
Tuesday, November 22, 11
9
EXPANSIONARY FISCAL POLICY IN
RESPONSE TO A SUPPLY SHOCK
Price
Index
The Discretionary
policy takes it up
further
Real GDP
Tuesday, November 22, 11
9
THE MULTIPLIER
• This isn’t in the book, but is a very important issue when
thinking about fiscal policy
• If I get $100 richer, I take my family out to a $100 dinner and leave
nice $20 tip
• The server takes her $20 tip and uses it to buy a $12 umbrella
• The umbrella store guy buys a burrito
• etc.
• The bottom line is a $100,000,000 stimulus might boost
GDP by more than $100,000,000
• This is the main argument for a stimulus or a job creation
package
• It depends on the marginal propensity to consume
• There are major fights about this in the popular press
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between various economists about this
Tuesday, November 22, 11
LIMITATIONS
• More than anything: there is no free lunch. If you lower
taxes or spend money today you need to raise taxes
tomorrow.
• Even if there is a large positive effect today there should
be a large negative effect tomorrow
• Plus there is deadweight loss of taxation so overall effects
might be negative
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Tuesday, November 22, 11
RICARDIAN EQUIVALENCE
• Some people argue it should be zero (Ricardian
Equivalence)
• Suppose interest rate is 10% and you give me $1000 today but will
raise my taxes by $1100 tomorrow.
• It shouldn’t have any actual effect on my spending, I am not any
richer
• I should just undo it by saving that money to pay my taxes
tomorrow
• However, most economist don’t believe this works perfectly
• People are not completely aware of what is going on
• Some of it will be distribution from some people to others
• Even more, could be redistribution from future generations to current
generations
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Tuesday, November 22, 11
FURTHER ISSUES
•Even if this doesn’t happen perfectly, there is reason to
believe that it might partly happen
•Further interest rates will automatically do some of this
•Government borrows
•This causes interest rate to go up
•People choose to save more
•Hiring workers might also lead to multiplier less than 1
•Government hires someone to build a highway
•That person might have gotten a job doing something else
•In this case you didn’t necessarily “create a job” for every worker
you hire
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Tuesday, November 22, 11
EVALUATING
NONDISCRETIONARY FISCAL POLICY
• Most economists believe that the built-in stabilizers have
had a modestly positive effect on diminishing the
severity of modern recessions.
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Tuesday, November 22, 11
THE MISTIMING OF
DISCRETIONARY FISCAL POLICY
• Recognition Lag: the time it takes to
measure the state of the economy
• Administrative Lag: the time it takes for
Congress to agree on a course of action
with the president
• Operational Lag: the time it takes for the
full impact of a government program or
tax change to have its effect on the
economy
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Tuesday, November 22, 11
POLITICAL PROBLEMS
WITH FISCAL POLICY
• Expansionary bias is the problem where
politicians are more willing to deal with
recessions with tax cuts and spending
increases than they are to deal with
inflationary pressures with tax increases
and spending cuts.
• The Political Business Cycle suggests that
politically motivated fiscal policy is used
for short term gain just prior to elections
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Tuesday, November 22, 11
THE RISE, FALL AND REBIRTH OF
DISCRETIONARY FISCAL POLICY
• Between 1975 and 2001 fiscal policy was
pretty much abandoned as a mechanism
for controlling the economy.
• Monetary policy was used to expand or
contract prices and GDP.
• In 2001, the impending recession
motivated tax rebates and the Sept. 11
attacks motivated a variety of tax cut and
spending increase ideas in Congress.
• In 2003, the continuing slow growth
motivated a renewal of the tax credit
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Tuesday, November 22, 11
THE 2003 REBATE
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Tuesday, November 22, 11
OBAMA STIMULUS PLAN
S"mulus Plan Element
Non-­‐Discre+onary Fiscal Policy: Unemployment, Welfare, Medicaid
Aid to States
Amount in Millions
$135,832 $53,600 Discre+onary Fiscal Policy: Tax Cuts
$301,135 Discre+onary Fiscal Policy: Spending Increases
$300,047 Tuesday, November 22, 11
CURRENT JOBS PACKAGE PROPOSED
BY PRESIDENT OBAMA
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•
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Total amount is around $450 billion
Payroll tax cut for businesses and workers
Tax breaks to businesses that hire
Tax credit to hire long-term unemployed
Extend unemployment insurance
Tax credit for veterans
Help refinance mortgages
Tax changes to pay for it(mostly raising taxes on rich)
Money for schools
Infrastructure projects
Prevent teacher, police and firefighter layoffs
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Tuesday, November 22, 11