The Role of the Government and

1
TOPIC 4

• The Role of the Government and
• Fiscal Policy

2

• The I-S Curve and Fiscal Policy

3
Fourth Major Curve of the Course IS curve

• IS curve represents demand side of the economy
  drawn in Y,r space
• Y C I G NX
• or (given definitions of disposable income and
  saving from lecture 1)
• S(hh) S(govt) I NX, or
• S I NX
• The IS curve is so named because it documents the
  relationship between Saving and Investment
  (holding NX constant).
• Reading Notes 9

4
Fourth Major Curve of the Course IS curve

• C is a function of PVLR (Y, Yf, W), tax policy,
  expectations (i.e., consumer confidence),
  liquidity constraints
• I is a function of r, A, business confidence,
  liquidity constraints, and investment tax
  policy.
• G is a function of government policy (we will
  discuss this shortly)
• NX we will model in the last lecture of the
  course (for the U.S., NX is small)
• The IS curve relates Y to r. How do interest
  rates affect Y?
• As r falls, Investment increases (due to MPK and
  firm profit maximization behavior).
• IS curve is downward sloping in r, Y space.
• For next week or two we will IGNORE the supply
  side of the economy (just to build intuition) ---
  after that, we will put demand and supply
  together.

5
Demand Side Analysis (IS Curve)

r
r
r
IS
Y
Y
Suppose r is set by the Fed at the level of r
(we will explore this in depth later in the
course). For a given r, we can solve for the
level of output desired by the demand side of the
economy.
We represent the demand side of the economy,
drawn in r,Y space as the I-S curve. Why IS?
Because the demand side of the economy can be
boiled down to I S (when NX is zero) Note Y
need not equal Y - I drew it this way for
illustrative purposes.
6
Some Thoughts on IS Curve

• What shifts the IS curve? Reading from reading
  list Notes 9
• Anything that causes C, I or G to change (or NX
  when we model it).
• What shifts IS curve to the right? (i.e., makes Y
  higher on the demand side of the economy)
• Increase in consumer confidence (expectations of
  future PVLR)
• Permanent increase in stock market wealth.
• A permanent reduction in income taxes (if
  households are PIH or Keynesean)
• A temporary reduction in income taxes (if
  households are Keynesean or Liquidity Constrained
  PIH).
• An expected future increase in TFP (stimulates
  investment demand).
• An increase in government spending (i.e., war).
• Changes in r WILL NOT cause IS curve to shift
  (causes movement along IS curve).
• You should be able to answer Why does the IS
  curve slope down?

7
Suppose Consumer Confidence Falls

• Suppose consumer confidence falls (and no effect
  on Y). IS curve will shift in.

r
C falls
r
r
IS1
IS
Y
Y
Y1
Assume that investment, NX, and G do not change!
8
Fiscal Policy

• Fiscal policy is the use of government spending
  (G) and taxes (tn) to stabilize the economy.
• Governments can have
• Output targets
• Price targets
• Unemployment targets.
• Stabilizing the economy means moving the economy
  towards its targets. We will ignore price
  targets for now (we have no prices in our model
  yet).
• Suppose the government has an output target and
  suppose that target is Y (we will also explain
  why Y is a good target later in the course).
• Fiscal policy then would be the manipulation of G
  and tn to move the economy towards Y. (Assumes
  government knows where Y is - we will discuss
  other drawbacks to fiscal policy later in the
  course).

9
Example of Fiscal Policy Consumer Confidence
Falls

• Government can undo the decline in consumer
  confidence by increasing G or decreasing tn -
  this is fiscal policy

r
C falls
r
r
G increases
IS1
IS IS2
Y
Y
Y1
Compute Change in G If ?G -? consumer
confidence,
Y will remain unchanged (taking r as fixed)
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• A Look at U.S. Debt and Deficits

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U.S. Federal Deficit (Relative to GDP)
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U.S. Federal Deficit (Relative to GDP) Since 2006
13
U.S. Federal Debt (Relative to GDP) Since 1900
14
U.S. Total Government Debt (Relative to GDP),
Including State and Local Since 1900
15
U.S. Federal Debt (Relative to GDP) Since 2006
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• The Cyclicality of Government Budget Deficits

17
Some Additional Structure on Taxes and Transfers

• Let us start with some definitions about debts
  and deficits.
• Tax Revenues tnY (where tn is the
  marginal tax rate on income)
• Transfers Payments Tr g Y (where g is the
  relationship between transfers and income)
• Rationale for specifications
• When Y increases, taxes revenues increase (more
  earnings in economy).
• - This is built into the tax code.
• - You are taxed based upon what you earn.
• When Y increases, transfers payments fall (less
  people on welfare)
• - This is built into our social programs.
• - We transfer more money to people when their
  income is low.

18
Some Deficit Terminology

• Actual Government Deficits
• Outlays (G and Tr) Revenues (T)
• G Tr g Y - tnY G Tr (g tn)Y
• Note For now, ignore other government revenues
  and expenses (like interest on government debt).
  See text for further discussion if interested.
• Definition Structural Budget Deficit is the
  deficit that would exist if the economy were
  at Y
• Structural Budget Deficit G Tr (tn
  g)Y
• Note Difference between structural deficits and
  actual deficits is only due to differences
  between Y and Y.
• Cyclical Budget Deficits Actual Budget
  Deficits - Structural Budget Deficits.
• Cyclical deficits occur anytime Y does not equal
  Y! Reading Notes 11

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The Nature of Deficits

• Deficits are countercyclical! (They rise when Y
  falls and fall when Y rises)
• Even if the government has a policy (combination
  of G and T) that would lead to no deficits at Y
  (the target level of output for the economy),
  deficits could still occur.
• The reason Y does not always equal Y.
• Why do we get countercyclical deficits?
• Welfare Payments, Unemployment Insurance, and
  Tax System dampen the effects of consumption over
  the business cycle.
• T goes up when times are good (like in the late
  1990s).
• G/Tr goes up when times are bad (welfare
  payments).
• We refer to such policies that dampen consumption
  as automatic stabilizers
• Given automatic stabilizers (and potentially
  proactive governmental fiscal policies), cyclical
  deficits seem to be an inherent part of our
  economy.
• Reading from reading list 40-43

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Graphing Deficits When Policy Is Constant (ie, G,
T0, Tr0, g, tn fixed)

• Even when the structural deficit is close to zero
  ((G Tr )/(tn g) Y), actual deficits can be
  large when Y lt Y!

Deficit
Structural Deficit G Tr (tn g)Y
Y
Y
Actual Deficit G Tr (tn g)Y
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Graphing Deficits When Policy Changes

• What happens to actual and structural deficits
  when G increases to G?

Deficit
GTr
GTr
Structural Deficit G Tr (tn g)Y
Y
Y
Actual Deficit G Tr (tn g)Y
Changing government policy affects both
structural and actual deficits!
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Should Governments Try To Prevent Deficits?

• Examples U.S. Balanced Budget Amendment.
  Maastricht criteria for entry to European
  Economic and Monetary Union (EMU) that
  deficit/GDP be 3 or less and that debt/GDP be
  60 or less.
• Benefits Limit Spending If spend today,
  government must
• 1) Raise Taxes Now (changing taxes
  frequently creates economic uncertainty)
• 2) Raise Taxes in Future (higher taxes cause
  disproportionately more distortions )
• 3) Print Money In Future (could lead to
  inflation)
• Is there a cost? Yes - balanced budget
  amendments can make economic situations worse.
  Refer back to the example earlier in this lecture
  when consumer confidence fell.
• As Y fell, tax revenues fell. As tax revenues
  fell, deficits (cyclical) increased. If the
  government had to balance the budget, they would
  either have to cut G or increase T - both of
  which would cause the IS curve to shift further
  to the left.
• Conclusion - it may be bad to have policies
  requiring governments to eliminate all deficits,
  but there may be some benefits from eliminating
  structural deficits (see below).

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• Government Spending at Y (model preview)

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Increase in G at Y - Investment Adjusts
LRAS Y Yf(A,K,N)
r1
r
IS YCIG
Y
Y
Suppose we start at Y such that Y is pinned down
by the supply side (i.e., labor markets clear,
all resources used efficiently)
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Increase in G at Y - Investment Adjusts
LRAS Y Yf(A,K,N)

r1
I
r
G
IS1 CI1 G1
IS YCIG
Y
Y
Assumption Increase in G has no effect on
A! Model Increase in G has no effect on N (no
effect on labor supply or labor demand).
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What is the Effect of Running a Deficit at Y?

• Situation 1 Crowding Out of Investment
• Equation 1 Y C I G Equation 2 SHH
  Sgvt I (if NX 0)
• If Y is pinned down by supply side of economy
  (such that ?Y 0 if G increases), then either C
  or I must fall to offset increase in G (i.e., ?G
  - ?I).
• Why would I fall? Increase in interest rates
  (we will prove once we build a model of money
  market).
• What is the effect of falling I (due to
  increased G) on future generations? Lower I
  today, means lower K tomorrow. Lower K tomorrow
  means lower Y tomorrow (lower economic growth).
• If at Y, increase in deficit will hurt future
  generations unless the deficit has a non-trivial
  effect on A (given Cobb Douglas Production If
  ?A gt 0.3 ? K, then deficit could help
  future generations.)

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What is the Effect of Running a Deficit at Y?

• Situation 2 Ricardian Equivalence
• Adjustment occurs on C as opposed to I (to keep Y
  at Y)
• Definition Ricardian Equivalence Theory that
  states that consumers behavior is equivalent
  regardless if the government finances G
  (government expenditures) through increased
  taxes or through increased debt
• Key If the government floats debt to finance
  the spending today, consumers realize that the
  government, at some time in the future, will have
  to raise taxes to pay back the debt.
• Summary A reduction in taxes today (an increase
  in G today) will be seen as being accompanied
  by higher taxes in the future. Households will
  save today to fund the future tax increases
  (they expect disposable income in the future
  to fall). National Saving would remain
  unchanged.
• In terms of equations Y is fixed, C falls and
  Shh goes up (prevents crowding out of
  investment I can stay fixed)

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Does Ricardian Equivalence Hold?

• For the most part, there is little evidence to
  support the existence of Ricardian Equivalence.
• Why? Myopia
• Liquidity Constraints
• High Levels of Impatience.
• Do not care about bequests/future generations
• Timing of Taxes is Important (taxes are not
  lump sum).
• It does not mean that it will never hold (some
  people point to Japan in the mid 1990s).
• For the rest of the course, we will assume
  consumers are non Ricardian unless told
  otherwise. This means that consumers will not
  adjust their consumption downward today in
  expectation of an increase in taxes tomorrow.
• Ricardian consumers, however, would adjust their
  consumption downward today in expectation of
  increases in taxes tomorrow (because PVLR falls).
  

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• Government Spending During Recessions

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Net Benefits of Using Government Spending to
Influence Economy

• Kevin Murphy outlined this simple model at a
  Booth seminar on the stimulus bill in 2009 (I
  will refer to this as the Murphy Model). I
  have augmented the model slightly.
• Define
• G Increase in government spending
• 1-a Value of dollar of government spending
  (a measures the inefficiency of government
  spending relative to private sector (a1), the
  multiplier effect of government spending via
  additional private sector spending (a2), or the
  potential effect of government spending on
  future TFP (a3).
• f Fraction of the government spending
  produced using idle resources (i.e, not
  subject to crowding out).
• ? The relative value of idle resources
  (some resources have value even if they are not
  used in market production i.e, value of
  leisure or home production).
• d The deadweight cost per dollar of revenue
  from the taxation required to pay for the
  spending (we have to pay back the spending at
  some point).

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Net Benefits of Using Government Spending to
Influence Economy

• Benefits of Government Spending (using above
  notation)
• (1a2 a3) G (the value of the extra spending
  given the two multipliers)
• Costs of Government Spending (using above
  notation)
• a1 G (the waste of the government spending due
  to inefficiency)
• (1-f) G (some of the resources (1-f) would have
  been used anyway (1-f) measures the extent
  of crowding out)
• ? f G (the resources that were idle still
  had some value denoted by ?)
• d G (the cost of society in terms of dead
  weight loss of having to repay the debt in the
  future by raising taxes or reducing some
  other government spending).
• Net Benefit
• (1a2 a3 - a1) G (1-f)G - ?f G - d G
  (f(1-?) a2 a3 a1 d)G

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Net Benefits of Using Government Spending to
Influence Economy

• Question When is it good to engage in government
  spending to stimulate economy in recession?
• Answer When the net benefit from doing so is
  positive!
• According to the simple Murphy model, net benefit
  is positive when
• f(1-?) a2 a3 gt a1 d
• In words, government spending should be used to
  stimulate the economy in a recession if
• 1) There are lots of idle resources in the
  economy (f is high)
• 2) The value of those idle resources are small
  (? is small)
• 3) The multiplier effects of government spending
  are large (a2 a3 gt 0 )
• 4) The government spending is not inefficient
  (a1 0) or
• 5) Paying back the taxes is not too
  distortionary (d is small).

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Some Thoughts on Parameter Values (f)

• Positive Net Benefit of Government Spending
  f(1-?) a2 a3 gt a1 d
• When Y lt Y f gt 0 (some idle resources)
• - By definition, recessions are periods of idle
  resources.
• - For a given G, a bigger recession would yield
  a larger f (more idle resources).
• When Y Y f 0 (no idle resources)
• - By definition, if we are at Y there are no
  idle resources.
• - Positive Net Benefit of Government Spending
• a2 a3 gt a1 d
• - This can only occur if a2 a3 a1 is positive
  (given d is always positive)
• - a2 is likely to be smaller at Y (more on this
  below with few idle resources it is hard to
  generate some multiplier effects)

34
Some Thoughts on Parameter Values (?)

• Positive Net Benefit of Government Spending
  f(1-?) a2 a3 gt a1 d
• Suppose Y lt Y, what is ??
• Most machines have very little value when sitting
  idle (perhaps it is the foregone value of the
  depreciation)
• This is almost certainly leads to ? being pretty
  small.
• The value of workers sitting idle is harder to
  measure.
• Not working (leisure) has some value people do
  not like to work
• Temporarily not working is not like normal
  leisure time (need to find a job, creates stress
  which reduces the enjoyment of normal leisure
  activities, etc.).
• My sense that even in this case, ? is still
  relatively small.

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Some Thoughts on Parameter Values (a1)

• Positive Net Benefit of Government Spending
  f(1-?) a2 a3 gt a1 d
• The magnitude associated with a1, a2 and a3 are
  the most debated in the current economic
  environment.
• What is a1?
• a1 measures the inefficiency of government
  spending (the private sector may be able to build
  a road for X while the government cost to build
  the same exact road is 2X).
• - Governments are not bound by profit
  maximization (which promotes efficient use of
  resources).
• - Political reasons often get in the way of
  efficient resource allocation (think of current
  resources put into Detroit).
• - Estimates suggest that a1 gtgt 0 (governments
  are really inefficient)

36
Some Thoughts on Parameter Values (a2)

• What is a2?
• Government spending may lead to multiplier
  effects in the economy when Y lt Y
• - A dollar of spending will put money in
  someones pocket and that may lead to
  increased spending on other goods and services,
  etc.
• - If there are more ideal resources in the
  economy, a 1 increase in government spending
  can lead to even more than 1 worth of idle
  resources being used.
• - There needs to be idle resources for this
  multiplier to exist (otherwise, the spending
  would have already taken place).
• - I will do an example of this in two slides
• - Implies a2 gt 0

37
Some Thoughts on Parameter Values (a3)

• What is a3?
• Government spending can promote TFP in the
  economy (by providing public goods or undoing
  negative extranalities).
• - Government can improve infrastructure of
  economy.
• - Benefits of the infrastructure born by
  everyone.
• - Increases TPF (A).
• - Is only important to the extent that such
  infrastructure would not have been provided by
  the private sector.
• - Even if economy is at Y, this effect could be
  important.
• - Implies a3 gt 0 (if effects on TFP are
  positive).

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Why is There a Potential a2 multiplier When Y lt
Y?

• Suppose we have the following model
• C a b(Y T) ltlt assume some fraction
  of consumers are liquidity constrained
  so they act Keynesiangtgt
• I I0 I1 r ltltInvestment is negatively
  related to interest ratesgtgt
• T tn Y ltltMarginal tax rate on labor
  incomegtgt
• Other assumptions
• Transfers 0 G G0 Y ltlt Y
  closed economy (NX 0 always)
• What is the equilibrium level of Y?
• Y C I G a b(Y tnY) I0 I1 r G0
  
• Solve for Y (Use algebra one equation, one
  unknown)
• Y a I0 I1 r G0 / 1-b(1-tn)

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What is the a2 multiplier in the Simple Model?

• Given the Simple Economy on Previous Page
• Y a I0 I1 r G0 / 1-b(1-tn)
• What is the multiplier of a change in government
  spending (G) on Y?
• dY/dG 1/1-b(1-tn)
• What is b? Some estimates range from 0.3-0.4 in
  recession.
• Where are the estimates from? -- Micro data
  analyzing tax rebates (a change in taxes not a
  change in government spending).
• What is t? Marginal tax rate roughly 0.25-0.35
• What is the government spending multiplier in
  this simple model?
• dY/dG is approximately 1.3 (if b 0.35,
  t0.3) ? a2 0.3

40
Intuition on a2 Multiplier

• What is the intuition of the government spending
  multiplier?
• By increasing government spending, it puts money
  into the economy. (If the government hires a
  worker to build a road, it will put money in that
  workers pocket. If that worker was liquidity
  constrained before, he will now spend that money
  at your store putting money in your pocket (and
  so on)).
• A dollar of government spending can lead to more
  than a dollar of economic activity because it can
  stimulate spending by consumers (who plan to
  consume the fraction b of that dollar (net of
  taxes)).
• Assumptions needed for the multiplier to hold
• Y needs to be well below Y (resources have to
  be sitting idle).
• Consumers need to be liquidity constrained (b gt
  0 - they cannot be standard non liquidity
  constrained PIH).
• Short run aggregate supply effects (i.e., price
  effects) must be small ltlt we have not done this
  it is just for full disclosure we can discuss
  this later when we make our short run aggregate
  supply curvegtgt.

41
Estimating Net Multipliers in Policy Discussion

• Christy Romer (Former Chair of the Presidents
  Council of Economic Advisors)
• - Estimates the new government spending
  multiplier to be around 1.6
• - Does so by using time series analysis of large
  government spending changes (like wars)
• - I do not believe the time series analysis (too
  much other stuff going on standard errors are
  huge)
• See
• http//alaskakid.wordpress.com/2009/02/28/christy
  -romer-02-27-09-fiscal-stimulus-likely-effects-of-
  the-arra/
• Reading from reading list 49
• Robert Barro (Harvard Professor Potential Soon
  to be Nobel Prize Winner)
• - Estimates the net government spending
  multiplier to be around 0.8
• - Also uses time series analysis (roughly same
  data as Romer different empirical approach)
• - I still do not believe the time series
  analysis
• Reading from reading list 51
• http//online.wsj.com/article/SB12325861820460459
  9.html

42
My Thoughts

• 1. Multipliers are likely much higher in
  recessionary times than in non-recessionary
  times. The simple calculation we did earlier
  makes me think the recessionary multiplier could
  be around 1.3 (all else equal) (a2 0.3).
• 2. All else is not equal The government
  spending is not efficient (a1 gt 0).
• - With the past big stimulus program, I think
  the inefficiency was likely even higher than in
  the past. Have you ever tried to spend 400
  billion quickly AND efficiently? There is no
  chance that this was successful.
• - My sense is the inefficiently could be large
  (all else equal a1 0.5). A lot of the
  government spending will be wasted.
• Some of the spending however may actually
  increase future TFP (a multiplier on Y instead
  of Y).
• - With the current stimulus, some spending may
  increase future TFP. I am not sure how big this
  will be. Suppose , all else equal, a3 0.1 -
  0.2 higher because of effects on TFP).
• My best guess on (a1 a2 a3) was probably
  close to zero or negative!

43
My Thoughts (Continued)

• Bottom line
• Is it good to have a large fiscal stimulus in
  the current economic environment? If a1 a2
  a3 and ? is close to zero, the Murphy equation
  becomes
• f gt d
• What does this mean? We compare the benefit of
  using idle resources to the cost of distortions
  that will occur because we have to pay the debt
  back at some point later.
• However, a big stimulus (G) and being closer to
  Y both suggest that the increase in government
  spending will be detrimental to the U.S. economy
  in the long run.
• Why?
• Inefficiency costs increase (a goes up it is
  hard to spend more money efficiently)
• Less likely that there will be idle resources (f
  goes down)
• I would have thought harder about projects that
  increase TFP in the long run and allocated my G
  towards them!

44

• Definition Supply Side Economics

45
Supply Side Economics

• Any fiscal policy designed to stimulate the
  supply side of the economy (A, K and N)
• Examples
• 1) Changing marginal tax rates (stimulate N)
• As discussed before , these policies may not
  have big effects (off setting income effects and
  substitutions effects empirically small
  estimates of labor supply response).
• 2) Subsidizing A and K (investment tax credits,
  research and development subsidies, subsidizing
  education, etc.)
• These programs have been shown as being
  effective ways to promote economic growth within
  an economy.