The Role of Fiscal Policy Carl E. Walsh Professor, UC Santa Cruz September 6, 2002 ECON 521 Special Topics in Economic Policy Presented by: Sareh Rotabi

Introduction US recession in 2002 The recovery of the US economy from recent crash is on a bumpy path Indicators: -In the 2 nd Quarter of 2002, Real GDP growth on an annual rate barely grew over 1% (well below market expectations). -Unemployment after rising in 2001 has stabilized but has yet to show signs of declining. -The stock market continued to drop through most of July and has remained volatile. “This weak economic performance comes despite substantial stimulus from both MONETARY & FISCAL POLICIES”

Introduction Monetary policy: Since January 2001, Fed has reduces its interest rate from 6.25% in September 2000 to a current level of 1.75%. Expansionary fiscal policy: The federal government budget has shift from a surplus of 236 bn dollars in 2000 to a projected 2002 deficit of 157 bn dollars as Government expenditure increased and Tax rate declined. The active use of fiscal policy during a recession is somewhat unusual! In 1990 recession, G.W.Bush resisted attempts to use fiscal policy to stimulate the economy. In contrast, during the current recession both congress and the president have supported increase in G exp and Tax reduction as a way to stimulate economic Growth. The current recession & recession offer contrasting example of the use of fiscal policy. The author highlights some elements of the debate in economics over whether fiscal policy can play a useful role in combating business cycle downturns and issues involved in using Fiscal Policy to help stabilize Short-Run fluctuation in the economy.

Automatic Stabilizers and Discretionary Fiscal Policy Automatic Stabilizers -Fiscal expenditure & tax responds automatically as economic activity fluctuates. Ex. Gov spending and Tax payment. Discretionary Fiscal Policy -When government make discretionary fiscal changes in the face of an economic downturn. Expansionary Fiscal policy aim to boost demand and output in the economy either directly (Through greater G exp) or indirectly (Through Tax reduction that stimulate private consumption and investment spending).

The Problem of Lag Argument against using discretionary fiscal policy to combat recession emphasizes the long lag involved in changing fiscal policy in US. Why Fiscal Policy use (Discretionary) in the States during Mild Recession is AWKWARD? By the TIME a fiscal program is starting to boost business and consumer demand, that is: 1.After policy makers recognize that economic growth has slowed 2.Propose a fiscal package 3.Debate it 4.Pass it 5.Send it to the president for his signature The economy is likely to be RECOVERING!!!

The Roles of the Future Fiscal Policy -Expectation of future fiscal actions, and not just the current G exp, Tax can effect the economy. - The DIFFRENCE between CURRENT CHANGES in Spending or Taxes and EXPECTED FUTURE CHANGE is IMPORTANT because HOUSEHOLDS and FIRMS consider FUTURE ECONOMIC CONDITIONS, as well as CURRENT CONDITION in making their SPENDING DECISION. The IMPACT of a CHANGE in Fiscal Policy TODAY will depend on how it affects individuals’ EXPECTATION about FUTURE Gov Spending and Tax. Example: Temporary Tax cut on individuals Vs Investment Tax credit

Can Fiscal Expansion be Contractionary? YES, When expectations of the future fiscal policy are important, expansionary fiscal policy may actually be contractionary! Example: A government with a large budget deficit decides to raise its expenditure Consequences: 1.Financial markets may question the solvency of the government, or 2.Expect the tax will need to be raised in the future. This can cause the long- term interest rate to rise, restraining current investment spending and canceling out the expansionary effect of the government spending.

Alesina, Perotti and Tavares (1998) found that deficit reduction are more likely to be expansionary if they involve cut in Gov spending on GOVERNMENT WAGES and TRANSFER. In contrast, deficit reduction achieved through TAX INCREASE do seem to be contractionary. Interaction with Monetary Policy -Both fiscal and Monetary policy influence AD -There are situation in which Monetary policy might be unable to stimulate the economy. Ex. Great Dep, Japan in recent years

Conclusion The automatic Fiscal Stabilizer help moderate economic fluctuations The contribution discretionary fiscal policy can make in combating economic recession is more debatable The long lag that typically characterize major changes in fiscal policy WEAKEN the role discretionary policy can play during mild recession in the US economy. Automatic fiscal stabilizer and Discretionary Monetary Policy remain the PRIMARY POLICY TOOLS for MACRO-ECONOMIC STABILIZATION