AGGREGATE DEMAND POLICY IN PERSPECTIVE Chapter 14 AGGREGATE DEMAND POLICY IN PERSPECTIVE

Today’s lecture will: Identify six problems with fiscal policy and explain how those problems limit its use. Describe how automatic stabilizers work. Summarize the advantages and disadvantages of using monetary and fiscal policy. Discuss why economists often talk about policy regimes rather than simply policy.

Supply Side versus Demand Side Policies The interrelationship between AS and AD is captured in the circular flow diagram. AS creates an output and income, and hence the potential AD to buy that output. The AS/AD model separates long-run AS from short-run AD forces. Demand-side policies (monetary and fiscal policies) shift the AD curve. Supply-side policies work by increasing potential output.

Problems with Fiscal Policy Six assumptions of the AS/AD model lead to problems with fiscal policy: Financing the deficit has no offsetting effects. The government knows what the situation is. The government knows potential income. The government has flexibility in changing spending and taxes. The size of the government debt doesn’t matter. Fiscal policy doesn’t negatively affect other goals.

Financing the Deficit Doesn’t Have Offsetting Effects Some economists believe that government financing of deficit spending offsets the deficit’s expansionary effect. Crowding out – the offsetting of a change in government expenditures by a change in private expenditures in the opposite direction due to higher interest rates caused by government borrowing.

Partial Crowding Out AD2 AD1 AD0 SAS Price Level Net effect Y0 Y2 Y1 Real output

Knowing What the Situation Is Data problems limit the use of fiscal policy for fine tuning. Getting reliable numbers on the economy takes time. We may be in a recession and not know it. The government has large econometric models and leading indicators to predict where the economy will be in the future, but the forecasts are imprecise.

Knowing the Level of Potential Income No one knows for sure the potential (full-employment) income. Almost all economists believe that potential income is within an unemployment rate range between 3.5% to 10%. Differences in estimates of potential income often lead to different policy recommendations.

Flexibility in Changing Taxes and Spending Putting fiscal policy into place takes time and has serious implementation problems. Numerous political and institutional realities make it a difficult task to implement fiscal policy. Disagreements between Congress and the President may delay implementing appropriate fiscal policy for months, even years.

Size of the Government Debt Doesn’t Matter Although there is no inherent reason why activists policies should have caused persistent deficits, increases in government debt has occurred because: Early activists favored not only the use of fiscal policy, but also large increases in government spending. Politically it’s easier for government to increase spending and decrease taxes than vice versa.

Fiscal Policy Doesn’t Negatively Affect Other Goals A society has many goals: achieving potential income is only one of those goals. National economic goals may conflict. For example, when the government runs expansionary fiscal policy, the trade deficit increases

Building Fiscal Policy into Institutions To avoid the problems of direct fiscal policy, economists have attempted to build fiscal policy into U.S. institutions. Automatic stabilizers – any government program or policy that will counteract the business cycle without any new government action. Automatic stabilizers include: welfare payments unemployment insurance the income tax system.

How Automatic Stabilizers Work When the economy is in a recession, the unemployment rate rises. Unemployment insurance is automatically paid to the unemployed, offsetting some of the fall in income. Income tax revenues also decreases when income falls in a recession, providing a stimulus to the economy. Automatic stabilizers also work in reverse. When the economy expands, government spending for unemployment insurance decreases and taxes increase.

State Government Finance and Procyclical Fiscal Policy State constitutional provisions mandating balanced budget act as automatic destabilizers. During recessions states cut spending and raise taxes. During expansions states increase spending and cut taxes. Procyclical fiscal policy – changes in government spending and taxes that increase the cyclical fluctuations in the economy instead of reducing them.

State Government Finance and Procyclical Policy Economists have suggested alternatives to state government procyclical budget policy. States can establish rainy season funds- reserves kept in good times to offset declines in revenues during recessions. States could use a five-year rolling-average budgeting procedure as the budget they are required to balance.

Automatic Stabilizers Have Their Problems When the economy first starts climbing out of a recession, automatic stabilizers may slow down the process. Despite these problems, most economists feel that automatic stabilizers have played an important role in reducing fluctuations in the economy.

Has Demand Management Reduced Fluctuations? Before demand management Active demand management Modern period 20% 15 10 5 20 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Percent change in real GDP around the trend

Conventional Wisdom about Monetary and Fiscal Policy Monetary and fiscal policy are not tools to fine-tune the economy, but they can be useful in guiding it toward the macroeconomic goals. Monetary policy is more important in the short-run because it is more flexible and less influenced by politics. Long-run consequences of expansionary policy include: Inflation (monetary policy) Higher interest rates and crowding out (fiscal policy)

Conventional Wisdom about Monetary and Fiscal Policy 1. Inflation may worsen. 2. Capital outflow. 3. Trade deficit may increase. 1. Risks recession. 2. Increases unemployment. 3. Slows growth. 4. May help cause short-run problems. 5. Interest rates may rise. 1. Interest rates may fall. 2. Economy may grow. 3. Decreases unemployment. 1. Helps fight inflation. 2. Trade deficit may increase. 3. Capital inflow Expansionary Contractionary Monetary policy Disadvantages Advantages Option

Conventional Wisdom about Monetary and Fiscal Policy Option Advantages Disadvantages Fiscal policy Expansionary Contractionary 1. May increase output growth in the short run. 2. May help solve short-run political problems. 3. Decreases unemployment. 1. May help fight inflation. 2. May allow a better monetary/fiscal mix. 3. Trade deficit may decrease. 4. Interest rates may fall, stimulating investment and growth in the long run. 1. Budget deficit worsens. 2. Hurts country’s ability to borrow in the future. 3. Trade deficit may increase. 4. Upward pressure on interest rate, discouraging growth. 1. Risks recession. 2. Increases unemployment. 3. Slows output growth in the short run. 4. May help cause short-run political problems.

Alternatives and Supplements to Monetary and Fiscal Policy Any policy that affects autonomous spending without having offsetting effects on other expenditures can achieve the same results. Alternatives and supplements to monetary and fiscal policy include: Directed investment policies Trade policy Consumption policy

Directed Investment Policies: Policies Affecting Expectations Rosy scenario – government policy of making optimistic predictions and never making gloomy predictions. Gloomy government predictions can affect expectations and decrease investment and consumption spending. Government guarantees or promises of guarantees can bolster business confidence.

Autonomous Consumption Policy Making credit more available to consumers can expand aggregate demand. Economists watch indexes of consumer credit and consumer confidence to gauge the direction of the economy.

Trade Policy and Export-Led Growth Export-led growth policies – policies designed to stimulate U.S. exports and increase aggregate expenditures on U.S. goods. Policies that restrict imports have the same expansionary effect on income. Because global economies are independent, there is a risk of retaliation whenever a nation applies trade restrictions against another nation.

Exchange Rate Policies Exchange rate policy – a policy of deliberately affecting a country’s exchange rate in order to affect its trade balance. A low value of a country’s currency relative to other currencies encourages exports and discourages imports, and vice versa.

Credibility in Aggregate Demand Policy What people believe about policy significantly influences the effectiveness of that policy. Because changes in expectations can shift the AD curve, expectations complicate models and policymaking. Effective policy must be credible policy.

Rational Expectations Rational expectations – forward-looking expectations that use available information. If the public is convinced that the Fed’s sole goal is controlling inflation, the policy will be effective. People will react differently if they believe that the Fed is resolute about fighting inflation.

Uncertainty About the Effects of Policy The central role of expectations means that there is a great deal of uncertainty in the economy. What people believe is important in how they react to policy. How people react to policy determines how monetary and fiscal policy will work. Because people have different expectations, the impact of various polices is difficult to predict.

Policy Regimes and Expectations A policy regime is a rule. It is a predetermined statement of the policy that will be followed in various circumstances. A policy is a one-time reaction to a problem. It is chosen without a predetermined framework. Policy regimes can help generate the expectations that make the government’s tools work. The focus on credibility has led to a call for rules to guide policy rather than giving policymakers wide policy discretion.

Summary Fiscal policy is affected by the following problems: Interest rate crowding out. The government may not know what the situation is. The government may not know the economy’s potential income. Government can not respond quickly. The size of the government debt does matter. Economic goals may conflict. Activist policy is now built into U.S. institutions through automatic stabilizers. Economists’ challenge is to find the appropriate mix of policy to balance the trade-off between low unemployment, high growth, and low inflation.

Summary Three alternatives to monetary and fiscal policy are: Directed investment policies Autonomous consumption policy Trade policy Policy is a process, not a one-time event, and policy regimes are often more important than any particular policy. Credibility can be built by establishing policy rules, but the trade-off is that policymakers will be unable to respond to an unforeseen event.

Review Question 14-1 Identify three automatic stabilizers and explain how they would lessen the severity of a recession. Welfare payments, unemployment insurance, and income tax are automatic stabilizers. In the case of a recession, unemployment increases, so welfare payments and unemployment insurance increase, offsetting some of the decrease in income. With lower incomes, people pay less tax. An increase in government spending and a decrease in taxes is an expansionary policy that will increase AD. Review Question 14-2 What are the six assumptions of the AS/AD model that lead to problems with fiscal policy? 1. Financing the deficit has no effect. (It can cause crowding out). 2. The government knows what the situation is. (The government uses estimates of the mpe and other exogenous variables. 3. The government knows potential income. (There is a wide range of estimates). 4. The government has flexibility in changing spending and taxes. 5. Size of the debt doesn’t matter. 6. Fiscal policy doesn’t affect other economic goals.