Macro Chapter 12 Fiscal Policy: Incentives, and Secondary Effects

4 Learning Goals 1) 1)Explain the crowding-out effect 2) 2)Identify political incentives associated with fiscal policy 3) 3)Summarize both sides of the debate about the effectiveness of fiscal stimulus 4) 4)Investigate the effect fiscal policy has on aggregate supply

Fiscal Policy, Borrowing, and the Crowding-Out Effect

Basic components of Crowding- Out: Y = C + I + G + X If the government (public sector) spends more, G rises Then businesses, consumers, and foreigners (private sector) spend less, C, I, and X fall Net effect is zero or a small positive increase in Y

First Secondary Effect: When the gov’t spends more, it either needs to borrow more or raise taxes to fund that spending If the gov’t borrows more, the demand for loanable funds increases which increases interest rates When interest rates increase, consumers buy less and businesses invest less If the gov’t raises taxes, consumers and businesses have less income which causes C and I to fall

Second Secondary Effect: If the gov’t borrows more, the demand for loanable funds increases which increases interest rates Higher interest rates will attract foreign investment which will cause the dollar to appreciate (because the demand for the dollar will increase) When the dollar appreciates, US exports fall and imports rise (net exports fall)

Fiscal Policy, Future Taxes, and the New Classical Model

Skim on your own You are not expected to know details

Political Incentives and the Effective Use of Discretionary Fiscal Policy

Another problem is the nature of government spending: Some spending may benefit only a small group of people Referred to as pork barrel spending

Fiscal Policy: Countercyclical versus Response during a Severe Recession

Will fiscal stimulus speed recovery from a recession? Argument for Yes: Only some crowding-out will occur so output will increase The multiplier is large so an increase in G will have a big effect Interest rates are weak incentives

Will fiscal stimulus speed recovery from a recession? Argument for No: More government spending now will lead to higher interest rates and taxes later Stimulus spending will increase structural unemployment Politically driven spending is inefficient

Are tax cuts a better tool than government spending? Argument for Yes: Tax cuts work faster Tax cuts are more efficient-you spend your money better than someone else spending it for you Tax cuts are easier to reverse Tax cuts increase the incentive to invest and produce

Are tax cuts a better tool than government spending? Argument for No: People will save their money rather than spend it Government spending can be directed to certain areas; tax savings will go different places Government doesn’t want to give up that revenue

Paradoxes of Thrift and Spending

Skim on your own

The Supply-Side Effects of Fiscal Policy

See Mankiw- “I can afford higher taxes” article in course library in Blackboard Mankiw- “I can afford higher taxes”Mankiw- “I can afford higher taxes”

Fiscal Policy of the United States

Here is a brief history of how we arrived at our thinking today See (again) Supplemental Videos: Commanding Heights 1, Chapters 1 through 8 For more information, see Or Google “commanding heights”