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Macro Chapter 12
Fiscal Policy, Incentives, and
Secondary Effects
4 Learning Goals
1) Explain the crowding-out effect
2) Identify political incentives associated with
fiscal policy
3) Investigate the effect fiscal policy has on
aggregate supply
4) Summarize both sides of the debate about the
effectiveness of fiscal stimulus
Transmitter question next
Survey Question:
Which way of thinking most closely resembles your view?
1. Government intervention is necessary and helpful to
direct economic outcomes.
2. Market forces work better than government intervention
and that intervention is likely to do more harm than good.
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Fiscal Policy, Borrowing,
and the Crowding-Out
Effect
Basic components of CrowdingOut:
Class Activity: Draw the loanable funds
market graph. Increase the demand for
loanable funds. What happens to the
interest rate?
Class Activity: Draw the foreign exchange
market graph. Which curve shifts when
foreigners want more dollars? Does the
dollar appreciate or depreciate?
Basic components of Crowding-Out:
Y=C+I+G+X
If the government (public sector) spends
more, G rises
Then businesses, consumers, and
foreigners (private sector) spend less; C, I,
and X fall
Net effect is zero or a small positive
increase in Y
First Secondary Effect:
When the gov’t spends more, it either
needs to borrow more or raise taxes to
fund that spending
If the gov’t borrows more, the demand for
loanable funds increases which increases
interest rates
When interest rates increase, consumers
buy less and businesses invest less
If the gov’t raises taxes, consumers and
businesses have less income which
causes C and I to fall
Second Secondary Effect:
If the gov’t borrows more, the demand for
loanable funds increases which increases
interest rates
Higher interest rates will attract foreign
investment which will cause the dollar to
appreciate (because the demand for the
dollar will increase)
When the dollar appreciates, US exports
fall and imports rise (net exports fall)
Two Transmitter questions next
Q12.1 The crowding-out model implies that a
1. budget surplus will be highly effective against
inflation.
2. budget deficit is likely to stimulate aggregate
demand and cause inflation.
3. budget deficit will increase real interest rates
and, thereby, reduce private spending.
4. budget surplus will reduce aggregate demand
and throw the economy into a downward spiral.
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Q12.2 The crowding-out model implies that
restrictive fiscal policy will
1. increase aggregate demand and employment.
2. lead to a significant increase in the natural rate
of unemployment.
3. be highly effective against inflation.
4. reduce real interest rates.
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Fiscal Policy, Future
Taxes, and the New
Classical Model
Skim on your own
You are not expected to know details
Political Incentives and
the Effective Use of
Discretionary Fiscal
Policy
Combine with next section
Is Discretionary Fiscal
Policy an Effective
Stabilization Tool?
Luigi Zingales:
The main difference between Keynes and
modern economics is the focus on
incentives. Keynes studied the relation
between macroeconomic aggregates,
without any consideration for the
underlying incentives that lead to the
formation of these aggregates. By
contrast, modern economists base all their
analysis on incentives.
John M. Keynes
The General Theory
It is my belief that much unnecessary
perplexity can be avoided if we limit
ourselves strictly to the two units, money
and labour, when we are dealing with the
behaviour of the economic system as a
whole; reserving the use of units of
particular outputs and equipments to the
occasions when we are analysing the
output of individual firms or industries in
isolation.
Summary:
Fiscal policy is believed to be less
effective than when Keynes first
prescribed it
The Supply-Side Effects
of Fiscal Policy
What are other effects of fiscal policy?
Class Activity: Economics is Everywhere 19.1
In the Beatles’ song, the “Tax Man” sings, “There’s
one for you, nineteen for me.” The Beatles are
complaining about the high marginal tax rate that
they faced in the United Kingdom in the 1960s.
Implicitly, each extra pound that they earned left
them only one shilling (one-twentieth of a pound in
the old British money), with the remaining nineteen
shillings going to the tax collector. This is clearly
about the marginal tax rate, the tax on each extra
bit of earnings, not the average tax rate, the ratio
of taxes to total income. No tax system has an
average tax rate of 95 percent on the entire tax
base. The 95 percent marginal rate is also
probably an exaggeration: Most systems have
loopholes that allow some income to escape
taxation when the rate is this steep. That Sir Paul
McCartney is now a billionaire is pretty good
evidence that the Beatles never really paid 95
percent of their earnings in taxes.
Class Activity : Make up an annual income for
yourself. What is your marginal tax rate? How
does that differ from your average tax rate?
Historical highest marginal tax rates:
Historical tax rates:
A tax story
Optional credit: Kamerschen tax story.pdf
Read the article, write a one-half to one page
summary on how you would divide the $20
refund, and why you would divide it that way.
Upload your document to Blackboard by ___.
Some other details of tax payments
Video:
See Mankiw- “I can afford higher taxes”
article in Blackboard (not for optional
credit, just FYI)
Transmitter Question Next
Q12.6 If the government cuts the tax rate, workers
get to keep
1. less of each additional dollar they earn, so work effort
increases, and aggregate supply shifts right.
2. less of each additional dollar they earn, so work effort
decreases, and aggregate supply shifts left.
3. more of each additional dollar they earn, so work effort
increases, and aggregate supply shifts right.
4. more of each additional dollar they earn, so work effort
decreases, and aggregate supply shifts left.
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Fiscal Policy and
Recovery from
Recessions
Will fiscal stimulus speed
recovery from a recession?
Argument for Yes:
Only some crowding-out will occur so
output will increase
The multiplier is large so an increase in G
will have a big effect
Interest rates are weak incentives
Will fiscal stimulus speed
recovery from a recession?
Argument for No:
More government spending now will lead
to higher interest rates and taxes later
Stimulus spending will increase structural
unemployment
Politically driven spending is inefficient
Let’s see, recovery.gov
Are tax cuts a better tool than
government spending?
Argument for Yes:
Tax cuts work faster
Tax cuts are more efficient-you spend your
money better than someone else spending
it for you
Tax cuts are easier to reverse
Tax cuts increase the incentive to invest
and produce
Are tax cuts a better tool than
government spending?
Argument for No:
People will save their money rather than
spend it
Government spending can be directed to
certain areas; tax savings will go different
places
Government doesn’t want to give up that
revenue
Two Transmitter questions next
Q 12.4 Historically, Keynesian economists have
argued that government spending will stimulate
aggregate demand more than tax cuts because
1. government spending will stimulate aggregate demand
more quickly than a tax cut.
2. there are fewer adverse side effects to an increase in
government spending.
3. all of the spending will add to aggregate demand, but a
portion of the tax cut will be saved.
4. an increase in government spending can quickly be
reversed once the economy has recovered.
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Q12.5 According to non-Keynesians, how will an
increase in government spending financed by
borrowing during a recession affect recovery?
1. Higher future taxes and interest rates will be required to
finance the larger debt and this will weaken the recovery.
2. Repayment of the debt can always be shifted to the future,
making it possible to keep tax rates low and thereby
strengthen the recovery.
3. Higher interest payments will increase future government
spending, and thereby promote a stronger the recovery.
4. The increase in government spending will exert a multiplier
effect on the economy, leading to a stronger recovery.
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U.S. Fiscal Policy: 19902013
You are seeing the debate unfold
before you
On January 1, 2009, the national debt was
$10.7 trillion.
Today, the national debt is over $17 trillion
For numbers overload, visit
usdebtclock.org
Who does the U.S. owe?
See Special Topic 8 The Federal Budget
and the National Debt for details
The debt is divided into 2 categories:
privately held (about 60%) and public
(about 40%)
Of the privately held debt, about one-half
is owned by foreigners
"The fact that we are here today to debate raising
America 's debt limit is a sign of leadership failure. It
is a sign that the US Government cannot pay its own
bills. It is a sign that we now depend on ongoing
financial assistance from foreign countries to
finance our Government's reckless fiscal policies.
Increasing America 's debt weakens us domestically
and internationally. Leadership means that, "the
buck stops here.' Instead, Washington is shifting the
burden of bad choices today onto the backs of our
children and grandchildren. America has a debt
problem and a failure of leadership. Americans
deserve better."
March, 2006
Senator Barack Obama
If you’re more interested:
Fiscal stimulus package-Feb 2008
How federal spending has climbed since
2001
US government finance graphs
WSJ-Short primer on the national debt
Video:
How Much is a Trillion?
Inquiring minds want to know
What does one TRILLION dollars look like?
All this talk about “stimulus packages” and “bailouts”...
A billion dollars...
A hundred billion dollars...
Eight hundred billion dollars...
One TRILLION dollars...
What does that look like?
Here’s a hundred bucks
We’ll start with a $100 dollar bill. Currently the largest
U.S. denomination in general circulation. Most everyone
has seen them, slightly fewer have owned them.
Guaranteed to make friends wherever they go.
Serious coin
A packet of one hundred $100 bills is less than 1/2" thick
and contains $10,000. Fits in your pocket easily and is
more than enough for a week or two of shamefully
decadent fun.
One Million Dollars!!!
Believe it or not, this next little pile is $1 million dollars
(100 packets of $10,000). You could stuff that into a
grocery bag and walk around with it.
That’s what I’m talkin’ about!
While a measly $1 million looked a little unimpressive,
$100 million is a little more respectable. It fits neatly on a
standard pallet...
Holy cow!
And $1 BILLION dollars... now we’re really getting
somewhere...
Please have a seat
Next we’ll look at ONE TRILLION dollars. This is that
number we’ve been hearing so much about.
What is a trillion dollars? Well, it’s a million million.
It’s a thousand billion.
It’s a one followed by 12 zeros.
You ready for this?
$1 Trillion dollars:
And notice those pallets are double stacked $100 dollar bills!
So the next time you hear your Congressman toss around the phrase
“trillion dollars”... that’s what they’re talking about.
Transmitter question next
Survey Question:
Which way of thinking most closely resembles your view of
fiscal policy?
1. I mostly agree with Keynes. Market forces either don’t
work as well as predicted or work too slowly to return the
economy to full employment. Government intervention
is necessary.
2. I mostly agree with New Classical Economists and
Hayek. Market forces work better than government
intervention and that intervention is likely to create
secondary effects which will inhibit growth.
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2.
Thomas Jefferson:
“A government big enough to give you
everything you want is strong enough to
take everything you have.”
4 Learning Goals
1) Explain the crowding-out effect
2) Identify political incentives associated with
fiscal policy
3) Summarize both sides of the debate about the
effectiveness of fiscal stimulus
4) Investigate the effect fiscal policy has on
aggregate supply