Chapter 17 Fiscal Policy

Fiscal Policy and the Budget Process Fiscal policy is the government’s policy with respect to its budget position (G-T) Ceteris paribus, big budget deficits (G>T) are stimulative, adding demand to the economy Big budget surpluses (G<T) are contractionary, taking demand out of the economy

Fiscal Policy and the Budget Process US budget process Congress and the President come up with the plan for taxing and spending Budget covers one year

Fiscal Policy and the Budget Process Deficit is a one year shortfall National debt – the cumulative effect of years of deficits If there were deficits in previous years, there will be interest that has to be paid on the national debt Interest is paid to the bondholders

Fiscal Policy and the Budget Process If the government doesn’t pass a budget The Treasury department couldn’t pay the interest on that debt The government would default on its debt obligations This has never happened in the U.S.

Fiscal Policy and the Budget Process Such a default would Undermine confidence of lenders This makes it harder for a nation to get capital flows into their country This is an issue for many developing nations, as we will see later

Implementation of Fiscal Policy If there is unemployment, Government can change its budget position to stimulate the economy It can raise G, or cut T, or both In order to move AD right

A carefully planned intervention Can move the economy to full employment May cause inflation due to the shape of the AS line May cause other problems, too

When the government runs a deficit, it has to make up the difference by borrowing The source for the borrowing is the capital market We’ve always used D I for the demand for private investments Now, we have the government’s demand for capital to cover its debts, which we’ll call D G

This additional demand causes higher interest rates Some private investors may not borrow to do projects they would have done, because the higher interest rates make the project less worthwhile Economists call this crowding out

The crowding-out effect

Before the government entry, the interest rate was r 0, total capital was TQ 0 Since all capital was going toward private investment, private investment, I 0, was equal to TQ 0

With the government entry due to the budget deficit, interest rates rise to r 1, and total capital exchanged moves out to TQ 1 However, private investment at the new rate of r 1 is only I 1 you lose investment from I 0 to I 1 we say this investment is “crowded out”

Understand that private investor’s demand has not changed The higher interest rate just makes fewer investments worthwhile

The size of the crowding out effect depends on the elasticity of the capital supply curve Inelastic - large crowding out Elastic - small crowding out

Governments demanding capital due to big budget deficits may bring other changes If suppliers think this budget deficit is a wise policy, then their confidence may increase the supply of capital to the nation’s capital markets This may diminish the crowding-out effect

However, If the government’s budget deficits seem irresponsible, and suppliers seem less confident, their withdrawal of capital may raise interest rates even further and make the crowding-out effect and fall in I even greater

The government budget position will also have an effect on international capital flows These flows will, in turn, affect the trade balance

Suppose, ceteris paribus, The U.S. government runs a big budget deficit Higher interest rates cause some capital to flow into the U.S. The demand for dollar increases, the supply of Euros increases, and the dollar becomes stronger More imports, less exports, and AD moves back leftward

All these problems (crowding out, higher interest rates, stronger dollar, etc.) can be avoided if the Fed is willing to expand the money supply This is called monetization of the deficit The problem with this is that, as with any money supply expansion, it may set off inflation

Non-interventionists argue that using expansionary fiscal policy isn’t necessary They think unemployment will fix itself, as demand deficient unemployment leads to lower wages, which move AS downward

Non-interventionists feel expansionary fiscal policy is not only unnecessary, but fruitless and distorting In trying to move AD right by running budget deficits, crowding out will cause I to fall (moving AD left) and cause a stronger dollar which increase M and decreases X (also moving AD left)

Further, If the these problems are small, or if the Fed works to offset them, you get the risk of inflation or a wage-price spiral

Interventionists feel fiscal policy is a powerful tool which can help millions who are suffering in a sluggish economy They contend that “waiting for markets to adjust” is not helpful, and non-intervention is naive

Non-interventionists point out that fiscal policy is especially difficult to implement because of political considerations Fiscal policy is not only determined by the President, but by 535 members of Congress At least monetary policy is in the hands of a small body (Fed) and one chairman (Bernanke)

Every politician wants to cut taxes and get more government spending in their particular district This is politically popular, but the aggregate of these micro choices lead towards a macro tendency of deficit spending

Some non-interventionists feel the only way to overcome this is to have a constitutional amendment requiring a balanced budget This is similar to the idea of a gold standard with monetary policy, because it restricts government’s ability to influence the economy

Interventionists feel that locking fiscal policy into a balanced budget is foolish Things come up that demand changes in government spending Ex. Pearl Harbor, 9/11

Most policy debates are centered around different philosophical positions Interventionists have little faith in the markets to self-correct due to things like market power and market failure Non-interventionists have little faith in the government’s ability to solve problems

These two positions represent the poles in the debate Most economists are in between, but may lean one way or another Both sides use the same tools you now know to make their case It’s their assumptions that differ