Fiscal Policy 2

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Fiscal Policy 2
2
Discretionary Fiscal Policy

• Changes at the option of govt
• For beginning, assume 1) no effect planned
  private spending, 2) no effect supply

3
Expansionary Fiscal Policy

• 1) increase G
• Multiplier effect GDP jumps if in horizontal
  zone, growth output w/o inflation unemployment
  falls
• 2) reduce taxes
• Smaller MPC, greater tax cut necessary for same
  multiplication (6.67B? 5B AE? 20B GDP)
• 3) use both
• Create budget deficit

4
AE Recessionary Gap
AE
CGIXN0
CGIXN1
rGDP
510
490
5
AS
PL
AD0
AD1
rGDP
6
Contractionary Fiscal Policy

• Restrain demand-pull inflation
• 1) decrease G
• Negative multiplier effect
• 2) raise T
• Reduces S by MPS, reduces C by MPC greater tax
  cut than spending cut
• 3) combine
• Create budget surplus

7
AE Inflationary Gap
AE
rGDP
530
510
8
AS
PL
AD0
AD1
rGDP
9
Financing Deficits Disposing of Surpluses

• Servicing the Deficit
• 1) Borrow? crowding out effect? reduces private
  spending? reduces expansionary impact
• 2) Money creation (monetary policy) both more
  expansionary and inflationary

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• Budget surplus? anti-inflationary?
• No pay down debt? buy back bonds? money back
  into money market? IR fall? more borrowing and
  spending
• Yes impounding, lock box

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G or T?

• Liberals increase spending in recessions, raise
  taxes during expansion
• Conservative tax cuts during recession, cut
  spending during expansion

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Nondiscretionary Fiscal Policy
Built-In/Automatic Stabilizers

• Increases deficit during recession, increases
  surplus during expansion w/o policy change
• Direct relationship GDP and net taxes
• Transfer payments negative taxes
• More progressive (average tax rate T rev/GDP
  direct relationship) more stability
• Vs. proportional (constant avg TR) or regressive
  (avg TR inversely related)

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G and T
T
Surplus
G
Deficit
rGDP
More progressive steeper slope
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• Economic importance
• 1) Taxes reduce S and AD
• 2) Stability benefits from taxes, and the more
  progressive the better regressive taxes (State)
  make the problem worse
• Can diminish but not correct major changes eGDP

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Actual vs. Full-Employment Budget

• Built-in stabilizers mean cant tell if actual
  budget deficit/surplus is expansionary/neutral/con
  tractionary
• Actual budget more than fiscal decisions about G
  and T, must also look at level of GDP

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T
e
a
G
d
b
Cyclical deficit
c
GDP y2
GDP y1
17

• Actual Nominal
• Full-employment Budget Real
• Measures budget if economy at full-employment
  throughout year
• Structural deficit reflects configuration G and
  T independent of GDP
• Discretionary fiscal policy deliberate changes in
  full-employment deficit
• Actual Structural Cyclical
• Structural tells if budget expansionary/neutral/co
  ntractionary

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Balanced Budget Amendment

• Effectively eliminate fiscal policy
• Would lead to worsening recessions
• 1) Increase T
• 2) Reduce G
• 3) Combination
• ? contractionary

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T1
a
G1
b
GDP y1
GDP y2
20
T2
T1
a
G1
b
GDP y1
GDP y2
21
T1
a
G1
G2
b
GDP y1
GDP y2
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Fiscal Policy Problems

• Timing
• 1)Recognition lag
• Indicators hard to read/slow to appear
• 2) Administrative lag
• Talk, talk, talk dont you wish we lived in a
  dictatorship?
• 3) Operational lag
• Tax changes take effect faster

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Political

• Stability not sole goal
• Employment Act 1946
• War, equality, equity, anti-discrimination, etc.
• State and Local govt
• Pro-cyclical
• Expansionary Bias
• And taxes bad
• Political Business Cycle
• Short-term memory 2-3 year cycles of tax cutting
  and gov spending (pre-election) followed by tax
  hikes and budget balancing
• Not fully supported by evidence

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Criticisms of Crowding-Out Effect

• Effect during recession limited? improved profit
  expectations may offset higher IR
• Monetary policy accommodative monetary policy
  (expand M)? reduce effect (1960s) tight (hold
  M steady)? increase effect (1980s)

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Aggregate Supply and Inflation

• Fiscal policy that pushes AD into intermediate
  range? output dissipated into inflation

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FP in Open Economy

• Globalization may increase fluctuations,
  certainly complicates fiscal policy
• AD shocks unexpected growth foreign consumers
  causes overshot of FP

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Intended Expansionary Policy
AS
PL
AD0
AD1
rGDP
28
Actual Effect w/AD Shock
AS
PL
AD2
AD0
AD1
rGDP
29

• AD shocks could also cause overshot of
  contractionary policy
• Could theoretically correct for timing problems

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• Net Export Effect
• Expansionary policy? crowding-out? higher IR?
  increased foreign financial capital in US (higher
  rate of return for creditor)? higher demand US
  (required for investment)? appreciation (higher
  value US )? US goods more expensive abroad?
  lower net exports? reduces expansion, offsetting
  FP
• Contractionary policy has opposite effect
• However lower/higher foreign input prices shifts
  AS, offsetting effect