Offsets to Fiscal Policy

Side Effects (Offsets) to Fiscal Policy Fiscal Policy not a perfect science/often trial and error with expansionary and contractionary fiscal policy Expansionary Policy- greater AD/less unemployment but could lead to inflation Contractionary Policy- less inflation and lower prices, but could lead to unemployment HARD TO FIND THE PROPER COMBINATION BETWEEN UNEMPLOYMENT AND LOW INFLATION

Offsets to Fiscal Policy Fiscal Policy does not operate in a vacuum- there are consequences to these fiscal policy decisions If gov’t expenditures increase, how are these expenditures financed, and by whom and what is the effect on the interest rate If taxes increase, what does the gov’t do with those taxes What will happen if individuals worry about future taxes because the gov’t is running up a deficit?

Offsets to Fiscal Policy Direct Crowding Out Ricardian Equivalence Theorem Indirect Crowding Out Open-Economy Effect All of these offsets will have a diminishing or dampening effect on expansionary fiscal policy!

Possible Offsets to Fiscal Policy Direct Crowding Out Direct expenditures offsets Any increase in government spending in an area that competes with the private sector Ex- Gov’t providing milk at no charge to students who are already purchasing milk. * Simply substituting “G” for “C”. No real change in AD!

Possible Offsets to Fiscal Policy Indirect-Crowding Out- the tendency of expansionary fiscal policy to cause a decrease in planned investment or planned consumption usually due to a rise in interest rates (interest rate effect) So the reduction of “C” and “I” will have a diminishing effect on the expansion of AD. This is crowding out!! Due to higher interest rates, consumers and businesses will borrow less money Instead of sell bonds, gov’t could borrow from the loanable funds market- result is the same (higher interest rates)

The Supply of and Demand for Loanable Funds What is the loanable funds market? 2) Effect on the int.rate by the gov’t borrowing from the loanable Annual Interest Rate ie Qe D2 Quantity of Credit, or Loanable Funds, per Time Period

The Crowding-Out Effect Either by selling bonds or borrowing from loanable funds market, the effect is the same, increasing interest rates and a dampening effect on AD. LRAS 7.0 SRAS AD2 Expansionary policy causing deficit spending initially shifts AD to AD2. AD3 AD1 125 E2 E3 120 6.75 Due to crowding out (higher interest rates), AD shifts inward to AD3. 6.5 110 E1 Equilibrium GDP below full- employment GDP-- contractionary gap Real National Income per Year ($ trillions) More “G” but less “C” and “I”

Possible Offsets to Fiscal Policy The Open Economy Effect To increase “G”, deficit spending leads to an increase in interest rates (sell bonds/borrow loanable funds) Foreigners demand more U.S. securities as interest rates go up. Must pay for it in U.S. dollars. Demand for the dollar increases and supply of foreign currency increases to purchase those U.S. dollars.

Possible Offsets to Fiscal Policy The Open Economy Effect Value of the dollar increases (appreciates)- Remember stronger dollar Value of foreign currency decreases (depreciates) American goods become more expensive and foreign goods become cheaper Exports fall, imports rise Net exports fall- decrease of “(X-M)- causes decrease of AD

Ricardian Equivalence Theorem Belief that individuals take into account present fiscal decisions for the future Scenario- 1)Nation has balanced budget. 2) Nation wants to cut taxes (expansionary) but also wants to keep gov’t spending at constant levels. Deficit is created! Nation will be responsible to pay for this in future.

Ricardian Equivalence Theorem Realizing the deficit (with interest) will have to be paid back in the future with higher taxes, individuals may wish to save tax cut. Therefore tax cut has no effect on AD or economic growth. Similar situation- Gov’t spending increase, taxes constant. Seeing future deficit people will save and not spend.

Supply-Side Economics. Summarize the concepts behind supply-side economics. How does supply-side economics differ from Keynesian fiscal policy? What are the strengths and weaknesses of supply- side? Consider its effect on price level (inflation), unemployment, output, economic growth. What is the Laffer Curve? What is its significance?