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Chapter 17
Fiscal Policy
Fiscal Policy and the Budget Process
Fiscal policy is the government’s policy
with respect to its budget position (G-T)
Ceteris paribus, big budget deficits (G>T)
are stimulative, adding demand to the
economy
Big budget surpluses (G<T) are
contractionary, taking demand out of the
economy
Fiscal Policy and the Budget Process
US budget process
Congress and the President come up with
the plan for taxing and spending
Budget covers one year
Fiscal Policy and the Budget Process
Deficit is a one year shortfall
National debt – the cumulative effect of
years of deficits
If there were deficits in previous years,
there will be interest that has to be paid on
the national debt
Interest is paid to the bondholders
Fiscal Policy and the Budget Process
If the government doesn’t pass a budget
The Treasury department couldn’t pay the
interest on that debt
The government would default on its debt
obligations
This has never happened in the U.S.
Fiscal Policy and the Budget Process
Such a default would
Undermine confidence of lenders
This makes it harder for a nation to get
capital flows into their country
This is an issue for many developing
nations, as we will see later
Implementation of Fiscal Policy
If there is unemployment,
Government can change its budget position
to stimulate the economy
It can raise G,
or cut T,
or both
In order to move AD right
P
LAS
Effect of Fiscal
Stimulus
AS
AD'
AD
Y*
Y' YF
Figure 17.2.1 - Recession and Fiscal Stimulus
Y
A carefully planned intervention
Can move the economy to full employment
May cause inflation due to the shape of the
AS line
May cause other problems, too
17.2.2
When the government runs a deficit,
it has to make up the difference by borrowing
The source for the borrowing is the capital market
We’ve always used DI for the demand for private
investments
Now, we have the government’s demand for
capital to cover its debts, which we’ll call DG
r
S
r1
r0
DI + D G
DI
TQ0
TQ1
Q$
Figure 17.2.2 - Government Borrowing and the Capital Market
This additional demand
causes higher interest rates
Some private investors may not borrow to
do projects they would have done,
because the higher interest rates make the
project less worthwhile
Economists call this crowding out
17.2.3 The crowding-out effect
r
Amount Of Private Investment Crowded
Out by Government Borrowing
S
Amount that Gov.
Borrowing Drove
up Interest Rate
r1
.
r0
DI + DG
DI
Capital to Private
Investment:
I1
I 0=TQ0
Q$
TQ1
Before Gov. Entry
After Gov. Entry
Capital to Gov.
Figure 17.2.3 - Crowding-Out Effect
Before the government entry,
the interest rate was r0,
total capital was TQ0
Since all capital was going toward private
investment,
private investment, I0 , was equal to TQ0
With the government entry due to the
budget deficit,
interest rates rise to r1,
and total capital exchanged moves out to
TQ1
However, private investment at the new rate
of r1 is only I1
you lose investment from I0 to I1
we say this investment is “crowded out”
Understand that
private investor’s demand has not changed
The higher interest rate just makes fewer
investments worthwhile
The size of the crowding out effect
depends on
the elasticity of the capital supply curve
Inelastic - large crowding out
Elastic - small crowding out
Elastic Case
Inelastic Case
r
r
S
S
r1
r1
r0
r0
DI + DG
DI + D G
DI
I1
I0
DI
Q$
I1
I0
Q$
Figure 17.2.4 - Elasticity of Capital Supply and the Size of the Crowding-Out Effect - Cases
17.2.4
Governments demanding capital due to big
budget deficits may bring other changes
If suppliers think this budget deficit is a wise
policy,
then their confidence may increase the
supply of capital to the nation’s capital
markets
This may diminish the crowding-out effect
However,
If the government’s budget deficits seem
irresponsible,
and suppliers seem less confident,
their withdrawal of capital may raise interest
rates even further and make
the crowding-out effect and fall in I even
greater
17.2.5
The government budget position will also
have an effect on
international capital flows
These flows will, in turn, affect the trade
balance
C
r
S
S
r1
C1
r0
C0
D'
DI + DG
D
DI
Q0
Q1
Q$
Figure 17.2.5 - Government Borrowing and the Exchange Rate, Ceteris Paribus
$
Suppose, ceteris paribus,
The U.S. government runs a big budget
deficit
Higher interest rates cause some capital to
flow into the U.S.
The demand for dollar increases, the supply
of Euros increases, and
the dollar becomes stronger
More imports, less exports, and AD moves
back leftward
17.2.6
All these problems (crowding out, higher
interest rates, stronger dollar, etc.)
can be avoided if the Fed is willing to
expand the money supply
This is called monetization of the deficit
The problem with this is that,
as with any money supply expansion,
it may set off inflation
17.3.1
Non-interventionists argue that
using expansionary fiscal policy isn’t
necessary
They think unemployment will fix itself, as
demand deficient unemployment
leads to lower wages, which move AS
downward
17.3.2
Non-interventionists feel expansionary fiscal
policy is not only unnecessary,
but fruitless and distorting
In trying to move AD right by running budget
deficits,
crowding out will cause I to fall (moving AD
left)
and cause a stronger dollar which increase
M and decreases X (also moving AD left)
Further,
If the these problems are small, or if the Fed
works to offset them,
you get the risk of inflation or a wage-price
spiral
17.3.3
Interventionists feel fiscal policy is a
powerful tool
which can help millions who are suffering in
a sluggish economy
They contend that “waiting for markets to
adjust”
is not helpful, and non-intervention is naive
17.3.4
Non-interventionists point out that
fiscal policy is especially difficult to implement
because of political considerations
Fiscal policy is not only determined by the
President,
but by 535 members of Congress
At least monetary policy is in the hands of a small
body (Fed) and one chairman (Bernanke)
Every politician wants to
cut taxes and
get more government spending in their
particular district
This is politically popular, but the aggregate
of these micro choices lead towards a
macro tendency of deficit spending
Some non-interventionists feel
the only way to overcome this is to have
a constitutional amendment requiring a
balanced budget
This is similar to the idea of a gold standard
with monetary policy, because it restricts
government’s ability to influence the
economy
17.3.5
Interventionists feel that locking fiscal policy
into a balanced budget is foolish
Things come up that demand changes in
government spending
Ex. Pearl Harbor, 9/11
17.3.6
Most policy debates are centered around
different philosophical positions
Interventionists have little faith in the
markets to self-correct due to things like
market power and market failure
Non-interventionists have little faith in the
government’s ability to solve problems
These two positions
represent the poles in the debate
Most economists are in between, but may lean one
way or another
Both sides use the same tools you now know to
make their case
It’s their assumptions that differ