Download Chapter 18 power point - The College of Business UNR

Second Edition
Chapter 18
Fiscal Policy
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?
2
Introduction
 In 2008 the U.S. economy was falling
toward a severe recession
• S&P stock index was plummeting
• Third quarter of 2008 consumer spending
dropped by 3.7%.
 Two approaches were tried to encourage
spending:
• Tax rebate checks
• Large increase in government spending
 Both are examples of fiscal policy
3
Introduction
 In This Chapter We…
• Use the dynamic aggregate demand and
aggregate supply model to understand fiscal
policy. We look at situations…
 In which fiscal policy is most effective.
 When fiscal policy doesn’t matter.
 When fiscal policy is harmful.
• Two general categories of fiscal policy
 The government spends more money.
 The government cuts taxes.
• In either case, the goal is greater spending.
4
Fiscal Policy: The Best Case
 Effect of a decrease in consumer spending
growth,  C .
• This is equivalent to a decrease in velocity,  v
• 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.
 Let’s use the model to show this and how fiscal
policy can restore full employment.
5
Fiscal Policy: The Best Case
Inflation
rate
(p)
Solow
Growth
curve SRAS (pe = 7%)
7%
6%
(1) Consumers ↓AD →
↓real growth and↓ p
(a → b)
(2) Govt. ↑ spending
growth
(b → a)
a
b
(1)  C
(2)  G
AD(M  v  10%)
AD(M  v  5%)
-1% 0%
3%
Real GDP
growth rate
6
Fiscal Policy: The Best Case
 If government did nothing, In the long-run
wages will adjust and C will return to its
normal growth rate.
• The economy will move from b → a.
• The recession will be over.
 The point of increasing G is to end the
recession sooner.
• Important question: If government ↑ spending
growth, where does the money come from?
 Let’s consider this next.
7
Fiscal Policy: The Best Case
 Where Does the Money Come From?
• Higher taxes
• Increased borrowing
 In either case, other parts of AD will shrink
making the  G less effective.
 In the best case scenario…
• More spending creates growth which supports
increased spending.
• This is possible because the economy is
operating at less than full employment.
8
The Multiplier
 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 G .
Let’s use our model to see this.
9
The Multiplier
Inflation
rate
(p)
Solow
Growth
curve
Economy in
recession at point b:
(2) Govt. ↑ spending
a
growth
b→c
(3) Multiplier →  C
(3)  C
c→a
7%
6%
b
SRAS (pe = 7%)
(2)  G
(1)  C
AD(M  v  5%)
-1% 0%
3%
AD(M  v  10%)
Real GDP
growth rate
10
Check Yourself
 What are the two types of
expansionary fiscal policy?
11
The Limits to Fiscal Policy
 Four Major Limits to Fiscal Policy
1.
2.
3.
4.
Crowding out
A drop in the bucket
Timing
Real shocks
 Let’s look at each of these more closely.
12
Crowding Out
 Crowding Out – The decrease in private
spending that occurs when government
increases spending.
 Crowding out can occur in two ways
depending on how government finances
the fiscal policy:
• Raises taxes
• Borrows the money by selling bonds.
13
Crowding Out
 Government raises taxes to finance fiscal
policy
• Higher taxes reduce private spending.
• The greater the fraction of additional income
that consumers normally spend, the greater
will be crowding out.
 Implication: Fiscal policy will be most effective
when people are otherwise reluctant to spend their
own income.
14
Crowding Out
 Government sells 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
likely to be effective when the private sector is
reluctant to save or invest.
• because private spending will be less sensitive
to changes interest rates.
Let’s use the market for savings to see this.
15
Increase in Government Borrowing
Crowds Out Private Spending
Interest rate
Supply of Savings
Government borrows
$100 billion
9%
b
c
7%
Reduced
private
investment
(borrowing)
Increased savings =
reduced consumption
a
Private Demand +
$100 billion
government demand
Private Demand
$150
$200
$250
Savings/Borrowing
(billions of dollars)
16
Tax Rebates and Tax Cuts
 Tax Rebates
• 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.
17
Tax Rebates and Tax Cuts
 Cuts in tax rates have two expansionary
effects.
• Income effect – taxpayers have more
disposable income to spend.
• Incentive effect – taxpayers keep a greater
fraction of income resulting from increased
investment and work.
18
Special Case of Crowding Out:
Recardian Equivalence
 Ricardian Equivalence – when people see
that lower taxes today mean higher taxes
later. They save their tax cut to pay future
taxes.
• Describes some people but not all.
• To the extent that this occurs, bond-financed
tax cuts are less effective in the short-run.
 The next diagram sums up the different
cases of crowding out.
19
Limits to Fiscal Policy
20
A Drop In the Bucket
 Normally changes in fiscal policy are small in
terms of percentage of GDP.
• Non-security discretionary spending is less than
20% of the federal budget.
 Stimulus plan passed under President Obama
in 2009—largest since WWII.
•
•
•
•
$800-900 billion
Spread over 3 - 4 years.
At its peak, only about 2% of annual GDP
In September 2010 – unemployment remained at
9.6%.
21
A Matter of Timing
 By the time fiscal policy is in place,
economic conditions have often changed.
 Relevant lags:
• Recognition – Identification of the problem.
• Legislative – Congress must act.
• Implementation – Bureaucracies must carry
out the policy.
• Effectiveness – Policy takes time to work.
• Evaluation and adjustment—Did the policy
work? Have conditions changed?
22
A Matter of Timing
 Example—Kennedy Tax Cut
• Discussed in 1961; Proposed in 1962;
Enacted in 1964.
• Lowered marginal rates from 91% to 70% at
the top and from 20% to 14% at the bottom.
• Rates in between were cut by about 30%.
• Results:
 Had little effect on the economy until 1965-1967.
 Long-term effect on economic growth was
significant.
23
A Matter of Timing
 Example—Bush Tax Cuts
• Marginal rates were cut in 2001, 2002, and
2003.
• Each cut was less than 1% of GDP
• The economy was already recovering.
• Most went to relatively high income groups
who save a larger fraction of their income.
 Low income people pay little income tax.
• Result:
 Little effect on AD.
24
A Matter of Timing
 Monetary policy is also subject to lags,
but…
• Generally are shorter than for fiscal policy.
• Federal Reserve can act very quickly.
 e.g. After 9/11, the next day 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.
25
A Matter of Timing
 Automatic Stabilizers—changes in fiscal
policy that stimulate AD in a recession w/o
explicit action by policy makers.
• Welfare and transfer programs
 In a recession more people apply for welfare
assistance and unemployment benefits → ↑ income
→ C
• Consumption smoothing
 People drawing on savings during an economic
downturn.
 Credit cards can help consumption smoothing
26
Government Spending Versus Tax Cuts
As Expansionary Fiscal Policy
 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 spending by
definition.
• Tax cuts will increase spending only if people
spend and don’t save their new money.
27
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 G.
• Because the economy is at full employment
most of the increase in G will crowd out
private spending.
• Most of the effect shows up as ↑P.
• Let’s use our model to show how this works.
28
Effect of a Real Shock
Inflation
rate
(p)
16%
(1) Solow growth curve shifts
left:
↑p → SRAS shifts up
↓ real growth rate →
recession: a → b
Old
Solow
growth
New Solow
growth curve c curve
(2)  G → ↑AD
Result:
Even higher p ;
Slightly higher
growth: b → c
Old SRAS
8%
2%
New SRAS
b
(2)  G
(1)
Real
shock
a
-3% -1%
3%
AD(M  v  15%)
AD(M  v  5%)
Real GDP
growth rate
29
Check Yourself
 What happened to make the 2008 Bush
tax rebate less powerful than anticipated?
 Explain why a permanent cut in income
tax rates can create a larger fiscal stimulus
than a temporary cut?
 Keeping your answer to the previous
question in mind, why does a permanent
investment tax credit create a smaller
fiscal stimulus than a temporary
investment tax credit?
30
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.
 Governments usually operate like this…
• Increase spending in bad times.
• Increase spending in good times.
• Result: Rising debt
31
When Fiscal Policy Might Make
Matters Worse
 Interest payments on the debt can become a
large fraction of the budget.
 Excessive government borrowing can lead to
economic collapse.
 Example: Argentina
• Government debt rose to 150% of GDP.
• The country defaulted on its debt—the largest
default by a government in the history of the
world.
• Savings flowed out of the country to Miami and
other places.
32
When Is Fiscal Policy a Good Idea?
 When dealing with an emergency
• War, Worsening depression, Natural disaster
 When crowding out is less likely.
 Fiscal policy is most likely to matter when:
• When the economy needs a short-run boost,
even at the expense of the long-run.
• When the problem is a demand shock not a
real shock.
• When many resources are unemployed.
33
Takeaway
 Fiscal policy is most effective…
• In times of emergency
• When there unemployed resources
• When the economy needs a short-term boost.
 Fiscal policy is not good at boosting longterm growth.
 Fiscal policy sometimes doesn’t work…
• Because of “crowding out”.
• When people cut spending in fear of higher
future taxes—Ricardian Equivalence.
34
Takeaway
 Most changes in government spending are not
big enough to make much of a difference.
 Automatic stabilizers help stabilize AD.
 Some countries take fiscal policy too far.
• Accumulate large amounts of debt
• This can destabilize finances, currencies, and
sometimes even governments.
 Good fiscal policy may not do a lot of good
 Bad fiscal policy can do a great deal of harm.
35
Second Edition
End of Chapter 18