Offsets to Fiscal Policy

Side Effects (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 2 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 1) If gov’t expenditures increase, how are these expenditures financed, and by whom 2) If taxes increase, what does the gov’t do with those taxes 3) What will happen if individuals worry about future taxes because the gov’t is running up a deficit? 3

Offsets to Fiscal Policy 4 Indirect Crowding Out Ricardian Equivalence Theorem Direct 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 5 Ex- Gov’t providing milk at no charge to students who are already purchasing milk. * Simply substituting “G” for “C”.

Possible Offsets to Fiscal Policy 6 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) 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 7 Quantity of Credit, or Loanable Funds, per Time Period Annual Interest Rate D1 S1 ieie QeQe 1)What is the loanable funds market? 2) Effect on the int.rate by the gov’t borrowing from the loanable funds market? D2

The Crowding-Out Effect 8 AD 1 SRAS AD 2 Real National Income per Year ($ trillions) 0 LRAS E1E1 AD E2E2 E3E Equilibrium GDP below full- employment GDP-- contractionary gap Expansionary policy causing deficit spending initially shifts AD to AD 2. Due to crowding out (higher interest rates), AD shifts inward to AD 3. Either by selling bonds/borrowing from loanable funds market, the effect is the same, increasing interest rates and a dampening effect on AD. 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. 9

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- drop of “(X-M)- drop of AD 10

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 but also wants to keep gov’t spending at constant levels. 11 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. 12

Supply-Side Economics. 1. Summarize the concepts behind supply-side economics. 2. How does supply-side economics differ from Keynesian fiscal policy? 3. What are the strengths and weaknesses of supply- side? Consider its effect on price level (inflation), unemployment, output, economic growth. 4. What is the Laffer Curve? What is its significance?