1. Offsets to Fiscal Policy

2. 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
HARD TO FIND THE PROPER COMBINATION
BETWEEN UNEMPLOYMENT AND LOW INFLATION

3. Offsets to Fiscal Policy
Fiscal Policy does not operate in a vacuum- there are consequences to these fiscal policy decisions
If gov’t expenditures increase, how are these expenditures financed, and by whom and what is the effect on the interest rate
If taxes increase, what does the gov’t do with those taxes
What will happen if individuals worry about future taxes because the gov’t is running up a deficit?

4. Offsets to Fiscal Policy
Direct
Crowding
Out
Ricardian
Equivalence
Theorem
Indirect
Crowding
Out
Open-Economy
Effect
All of these offsets will have a diminishing or dampening
effect on expansionary fiscal policy!

5. 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
Ex- Gov’t providing milk at no charge to students who
are already purchasing milk.
* Simply substituting “G” for “C”. No real change in AD!

6. Possible Offsets to Fiscal Policy
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)
So the reduction of “C” and “I” will have a diminishing effect on the expansion of AD. This is crowding out!!
Due to higher interest rates, consumers
and businesses will borrow less money
Instead of sell bonds, gov’t could borrow from the loanable funds
market- result is the same (higher interest rates)

7. The Supply of and Demand for Loanable Funds
What is the loanable
funds market?
2) Effect on the int.rate
by the gov’t borrowing
from the loanable
Annual Interest Rate ie Qe D2
Quantity of Credit, or Loanable Funds,
per Time Period

8. The Crowding-Out Effect
Either by selling bonds or borrowing from loanable funds
market, the effect is the same, increasing interest rates and a dampening effect on AD.
LRAS
7.0
SRAS
AD2
Expansionary policy
causing deficit
spending initially
shifts AD to AD2.
AD3
AD1
125 E2 E3
120
6.75
Due to crowding out
(higher interest rates),
AD shifts inward
to AD3.
6.5
110 E1
Equilibrium GDP
below full-
employment GDP--
contractionary gap
Real National Income per Year
($ trillions)
More “G” but less “C” and “I”

9. 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.

10. 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- decrease of “(X-M)- causes decrease of AD

11. Ricardian Equivalence Theorem
Belief that individuals take into account present fiscal decisions for the future
Scenario- 1)Nation has balanced budget ) Nation wants to cut taxes (expansionary) but also wants to keep gov’t spending at constant levels.
Deficit is created!
Nation will be responsible to pay for
this in future.

12. 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.

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