Ch. 12: Fiscal Policy Pt. II

Actual vs. Full Employment Budget Full Employment Budget: because of automatic stabilizers, the actual budget deficit or surplus will vary with the size of GDP. (examples of Automatic Stabilizers: unemployment compensation, corporate profit tax, progressive income tax) Actual budget deficit or surplus… may differ greatly from full employment budget deficit or surplus estimates. Actual budget consists of structural deficit (or full employment) and the cyclical deficit. Structural deficits… occur when there is a deficit in the full-employment budget as well as the actual budget. Discretionary fiscal policy is reflected in deliberate changes in this structural deficit.

Fiscal Policy and the Crowding-out Effect The Crowding-out Effect: -- indicates that the increased borrowing to finance a budget deficit will push real interest rates up and thereby retard private spending, reducing the stimulus effect of expansionary fiscal policy. Likewise, a restrictive fiscal policy will reduce real interest rates and "crowd in" private spending

Crowding-out Private Spending in the Loanable Funds Market Price level r 1 Q D1 S1 e1 D2 Under this model, fiscal policy exerts a decrease on real GDP. e2 r 1 Q 2 In order to finance the budget deficit, the govt borrows from the loanable funds market, increasing aggregate demand (from D1 to D2). The supply of loanable funds decreases “crowding out” private investment.

A Visual Presentation of the Crowding-Out Effect in an Open Economy Decline in Private Investment Increase In Budget Deficit Higher Real Interest Rates Inflow of Financial Capital from Abroad An increase in govt. borrowing to finance an enlarged budget deficit places upward pressure on real interest rates. Appreciation of the Dollar Decline in Net Exports This retards private investment and thereby Aggregate Demand. In an open economy, higher interest rates attract capital from abroad. As foreigners buy more dollars to buy U.S. bonds and other financial assets, the dollar appreciates. In turn, the appreciation of the dollar causes net exports to fall. Thus, as a result of increased budget deficits, higher interest rates trigger reductions in both private investment and net exports, which has the opposite effect of the expansionary impact of a budget deficit.

“New Classical” View of Fiscal Policy The New classical view stresses that: debt financing merely substitutes higher future taxes for lower current taxes When debt is substituted for taxes: people will save the increased income so they will be able to pay the higher future taxes Therefore, the budget deficit does not stimulate aggregate demand (which is what it is supposed to do). According to the new classical view, fiscal policy is completely impotent. It does not effect output, employment, or real interest rates.

Tax Rates     High marginal tax rates will supposedly tend to retard total output because they will: 1.  Discourage work effort and reduce the productive efficiency of labor. 2.  Adversely affect the rate of capital formation.

Fiscal Policy: -- Problems with Proper Timing Various time lags make proper timing of changes in discretionary fiscal policy difficult. Discretionary fiscal policy is like a two-edged sword; it can both harm and help. Recognition Lag — leading indicators may not be up-to-date; recessions often are not recognized for 6 months Administrative Lag — wheels of government turn slowly Operational Lag — time for spending to take effect may be slower than tax changes

Why Proper Timing of Fiscal Policy is Difficult Goods & Services (real GDP) Price level LRAS AD0 P Y F SRAS E0 AD1 Shifts in AD are difficult to forecast! P 1 e1 Y 1 We begin long-run equilibrium (E0) at the price level P0 and output YF. At this output, only the natural rate of unemployment is present. An investment slump and business pessimism result in an unanticipated decline in AD (to AD1). Output falls and unemployment increases. After a time, policymakers institute expansionary fiscal policy seeking to shift AD back to AD0, but by the time fiscal policy begins to exert its primary effect, private investment has recovered and decision makers have become increasingly optimistic about the future.

Why Proper Timing of Fiscal Policy is Difficult Price level AD2 SRAS2 LRAS AD0 AD0 SRAS P 3 e4 P 2 e2 P E0 P 1 e1 AD1 Goods & Services (real GDP) Y 1 Y F Y F Y 2 Thus, just as AD begins shifting back to AD0 by its own means, the effects of fiscal policy over-shift AD to AD2. The price level in the economy rises as the economy is now “overheated”. Unless the expansionary fiscal policy is reversed, wages and other resource prices will eventually increase, shifting SRAS back to SRAS2 (driving the price level up to P3).

Why Proper Timing of Fiscal Policy is Difficult Goods & Services (real GDP) Price level LRAS P Y F SRAS AD0 E0 AD2 AD0 P 2 e2 E0 Y 2 Alternatively, suppose an investment boom disrupts the initial equilibrium shifting aggregate demand out to AD2, placing upward pressure on prices. Policymakers respond by increasing taxes and cutting government expenditures, but by the time that the restrictive fiscal policy has had an opportunity to take effect, investment returns to its normal rate (shifting AD2 back to AD0).

Why Proper Timing of Fiscal Policy is Difficult Price level LRAS AD0 SRAS AD1 P 2 e2 P E0 E0 P 1 e1 AD2 AD0 Goods & Services (real GDP) Y 1 Y F Y F Y 2 Thus, just as AD begins shifting back to AD0 by its own means, the effects of fiscal policy over-shift AD to AD1. The price level in the economy falls as the economy is now thrown into recession. Because fiscal policy does not work instantaneously, and since dynamic factors are constantly influencing private demand, proper timing of fiscal policy is not an easy task.

Empirical Evidence on the Impact of Fiscal Policy 18 20 22 24 26 1965 1960 1970 1975 Year 1980 1985 1990 1995 2000 < Revenues Expenditures Deficits Percent of Real GDP Fiscal policy during the past 4 decades: Since 1960 the federal budget as a % of GDP has generally increased during recessions and declined during periods of economic expansion.

Empirical Evidence on the Impact of Fiscal Policy Component as a % of GDP 1976–1980 1983–1987 1960–1974 1981–1994 Differential B Federal Deficit % Of GDP Time Period Personal Consumption Real Interest Rate A Gross Investment Less Net Foreign Net Private Exports The real interest rate was derived by subtracting the annual inflation rate as measured by the GDP deflator from the AAA corporate bond rate. Later period minus earlier period. As the data of the first column indicate, the federal deficits were larger during the later period. Source: Derived from the Economic Report of the President D ifferential 2.9 5.1 +2.2 0.9 4.0 +3.1 1.9 7.5 +5.6 2.4 6.1 +3.7 62.3 65.0 62.0 65.8 +3.8 17.5 16.7 -0.8 15.7 15.3 -0.4 0.0 2.6 +2.6 - 0.5 1.6 +2.1 14.1 -3.4 16.2 13.7 +2.5 0.8 -1.8 0.2 Consumption and Investment: As deficits rose from ‘83 to ‘87, consumption rose (from 62.2% to 65%), consequently savings fell (also in ‘81-‘84 period). Appreciation of the dollar, capital inflow and net exports: As deficits rose from ‘83 to ‘87, net foreign investment rose (from 0% to 2.6%), while net exports fell. (also in ‘81-‘84 period). This is consistent with the crowding-out model.