FISCAL POLICY AND PUBLIC FINANCE Chapter 30 FISCAL POLICY AND PUBLIC FINANCE

Today’s lecture will: Explain the logic of the Ricardian equivalence theorem. Distinguish sound finance from functional finance. List six assumptions of the AS/AD model that lead to potential problems with the use of fiscal policy. Describe how automatic stabilizers work. Distinguish the nuanced functional finance view of fiscal policy from the New Classical view of fiscal policy.

Classical Economics and Sound Finance Sound finance – the government budget should always be balanced except in wartime. Ricardian equivalence theorem – deficits do not affect the level of output because people increase savings to pay future taxes to repay the deficit.

Nuanced Sound Finance During the Depression of the 1930s economists began to question the theory of sound finance. Nuanced sound finance – a policy of sound finance should be maintained in a small recession, but a depression might require deficit financing.

Functional Finance Functional finance – governments should make spending and taxing decisions on the basis of their effect on the economy. If spending was too low, government should run a deficit; if spending was too high, government should run a surplus.

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.

Offsetting Effects of Financing the Deficit Interest rate S0 AD2 AD1 AD0 SAS i1 i0 Price Level D1 Net effect Partial crowding out D0 Quantity of loanable funds Y0 Y2 Y1 Real output I0 I1

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 activist functional finance 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.

Decrease in Fluctuations in the Economy

New Classical Public Finance New Classical macroeconomics is a theoretical approach to macroeconomics that revived many pre-Keynesian ideas. It is centered on the Ricardian equivalence theorem. It is criticized because it assumes the aggregate economy is a single representative agent and ignores coordination problems.

The Nuanced Keynesian and New Classical Views AD2 AD1 AD0 Price Level Price Level SAS SAS P0 AD0 Real output Q0 Real output

Incentive and Supply-Side Effects of Public Finance The Republican party used New Classical macroeconomics to justify tax cuts. Supply-side economics emphasized the incentive effects of tax cuts that would lead to growth. Tax cuts were designed to prevent the growth of government spending.

Summary Sound finance is a view that the government budget should always be balanced except in wartime. The Ricardian equivalence theorem states that it doesn’t matter whether government is financed by taxes or deficits; neither would affect the economy.

Summary Although proponents of sound finance believed the logic of the Ricardian equivalence theorem, they believed deficit spending could affect the economy. Still, because of political and moral issues, proponents of sound finance promoted balanced budgets. Functional finance is the theoretical proposition that governments should make spending and taxing decisions based on their effect on the economy, not moralistic principles.

Summary Six assumptions that make functional finance difficult to implement are: 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.

Summary The New Classical view is that the Ricardian equivalence theorem is not only theoretically true, it is also true in practice and, therefore, government should not use deficit spending. The nuanced Keynesian view is that deficit spending can crowd out private investment, reducing the effect of deficit spending on the economy, but deficit spending will increase output in the economy. New Classicals believe that growth is much more central to the well-being of individuals.

Review Question 30-1 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 30-2 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.