1. Chapter 18
Fiscal Policy

2. Chapter Outline Fiscal Policy: The Best Case
The Limits to Fiscal Policy
When Fiscal Policy Might Make Matters Worse
So When Is Fiscal Policy a Good Idea?

3. Introduction
In 2008 the U.S. economy was falling toward a severe recession
S&P stock index was plummeting
Third quarter of 2008 consumer spending dropped by 3.7%.
Two approaches were tried to encourage spending:
Tax rebate checks
Large increase in government spending
Both are examples of fiscal policy

4. Introduction In This Chapter We…
Use the dynamic aggregate demand and aggregate supply model to understand fiscal policy. We look at situations…
In which fiscal policy is most effective.
When fiscal policy doesn’t matter.
When fiscal policy is harmful.
Two general categories of fiscal policy
The government spends more money.
The government cuts taxes.
In either case, the goal is greater spending.

5. Fiscal Policy: The Best Case
Effect of a decrease in consumer spending growth,
This is equivalent to a decrease in velocity,
What happens?
AD shifts to the left
Because wages are sticky, the decline in velocity is split between lower real growth and lower inflation.
The economy goes into a recession.
Let’s use the model to show this and how fiscal policy can restore full employment.

6. Fiscal Policy: The Best Case
Inflation
rate
(p)
Solow
Growth
curve
SRAS (pe = 7%)
Consumers ↓AD → ↓real growth and↓ p
(a → b)
(2) Govt. ↑ spending growth
(b → a) 7% a b 6%
Instructor Note:
This a an animated diagram so you can explain as you “draw”.
If wages are flexible, all of the effect of the lower growth rate of consumption will be to lower inflation. The real growth rate will remain at the Solow growth rate.
Also recall that in the dynamic aggregate demand aggregate supply model the sum of inflation and real growth always equals the spending growth i.e. Growth rate of money + growth rate of velocity = inflation + real growth.
The exact amount of stimulus needed is not known, so the problem of overshooting or undershooting is the same with fiscal policy as it is with monetary policy.
Real GDP
growth rate
-1% 0% 3%

7. Fiscal Policy: The Best Case
If government did nothing, In the long-run wages will adjust and will return to its normal growth rate.
The economy will move from b → a.
The recession will be over.
The point of increasing is to end the recession sooner.
Important question: If government ↑ spending growth, where does the money come from?
Let’s consider this next.

8. Fiscal Policy: The Best Case
Where Does the Money Come From?
Higher taxes
Increased borrowing
In either case, other parts of AD will shrink making the less effective.
In the best case scenario…
More spending creates growth which supports increased spending.
This is possible because the economy is operating at less than full employment.

9. The Multiplier
Multiplier Effect – the additional increase in AD caused when expansionary fiscal policy increases income and thus consumer spending.
When government spends money, incomes of certain people rise. As these people spend their money, incomes of additional people rise and so on.
The greater the multiplier, the greater will be the effect of the increase in .
Instructor Note:
The multipliers the Congressional Budget Office used to analyze the 2009 stimulus package depended on the type of spending. It ranged from 0.1 to The complete list can be found at
Robert Barro, an economics professor at Harvard University and a senior fellow at Stanford University's Hoover Institution, argued that the average spending multiplier is less than one. A vigorous response ensued because if he is right, the stimulus package will have no effect. This article can be found at:
Let’s use our model to see this.

10. The Multiplier Inflation rate (p) Economy in recession at point b:
Solow
Growth
curve
SRAS (pe = 7%)
Economy in recession at point b:
(2) Govt. ↑ spending growth
b → c
(3) Multiplier →
c → a 7% a b 6%
Instructor Note:
This is a animated diagram so you can explain and you “draw”.
If the economy is in a recession as a result of a demand shock at point b, fiscal policy might be used to try to return the economy to full employment faster than it would otherwise.
An increase in the rate of government spending will shift the dynamic aggregate demand curve to the right for two reasons:
Government spending is a direct part of AD so an increase in the growth rate of G will increase the growth rate of total spending.
Because of the multiplier effect there will be a secondary effect as the rate of growth of household spending increases.
These two effects are shown as separate shifts (points 2 and point 3) in the diagram.
Real GDP
growth rate
-1% 0% 3%

11. Check Yourself
What are the two types of
expansionary fiscal policy?

12. The Limits to Fiscal Policy
Four Major Limits to Fiscal Policy
Crowding out
A drop in the bucket
Timing
Real shocks
Let’s look at each of these more closely.

13. Crowding Out
Crowding Out – The decrease in private spending that occurs when government increases spending.
Crowding out can occur in two ways depending on how government finances the fiscal policy:
Raises taxes
Borrows the money by selling bonds.

14. Crowding Out Government raises taxes to finance fiscal policy
Higher taxes reduce private spending.
The greater the fraction of additional income that consumers normally spend, the greater will be crowding out.
Implication: Fiscal policy will be most effective when people are otherwise reluctant to spend their own income.

15. Crowding Out Government sells more bonds to finance fiscal policy
The supply of bonds increases.
Bond prices fall → interest rates rise
Higher interest rates → less private spending.
Implication: Bond financed fiscal policy will be most likely to be effective when the private sector is reluctant to save or invest.
because private spending will be less sensitive to changes interest rates.
Let’s use the market for savings to see this.

16. Increase in Government Borrowing Crowds Out Private Spending
Interest rate
Supply of Savings
Government borrows $100 billion
Increased savings = reduced consumption 9% b c 7% a
Reduced private investment (borrowing)
Private Demand + $100 billion government demand
Private Demand
$150
$200
$250
Savings/Borrowing
(billions of dollars)

17. Tax Rebates and Tax Cuts
Rebate – taxpayers are handed a check.
Early 2008—Bush administration tried to stimulate AD by sending a total of $78 billion in tax rebates: $300-$600 per taxpayer.
Result: AD did not increase at all because most of the money was used to pay down debt.
A problem with tax rebates is that they are not permanent.

18. Tax Rebates and Tax Cuts
Cuts in tax rates have two expansionary effects.
Income effect – taxpayers have more disposable income to spend.
Incentive effect – taxpayers keep a greater fraction of income resulting from increased investment and work.
Instructor Note:
The incentive effect of cutting tax rates is the focus of “supply side” economic policy. Those advocating cutting tax rates argue that it is not only is the economy stimulated by the increased income people get to keep but the lower tax rate actually increases the incentive to work and invest which results in a higher Solow growth rate.
If income taxes rates are very high, it is possible for a cut in the tax rate to actually result in more government revenue being collected because of the increased size of the tax base.
Finally, it is important to understand that the incentive effect depends on the change in the tax rate being permanent.

19. Special Case of Crowding Out: Recardian Equivalence
Ricardian Equivalence – when people see that lower taxes today mean higher taxes later. They save their tax cut to pay future taxes.
Describes some people but not all.
To the extent that this occurs, bond-financed tax cuts are less effective in the short-run.
The next diagram sums up the different cases of crowding out.

20. Limits to Fiscal Policy

21. A Drop In the Bucket
Normally changes in fiscal policy are small in terms of percentage of GDP.
Non-security discretionary spending is less than 20% of the federal budget.
Stimulus plan passed under President Obama in 2009—largest since WWII.
$ billion
Spread over years.
At its peak, only about 2% of annual GDP
In September 2010 – unemployment remained at 9.6%.

22. A Matter of Timing
By the time fiscal policy is in place, economic conditions have often changed.
Relevant lags:
Recognition – Identification of the problem.
Legislative – Congress must act.
Implementation – Bureaucracies must carry out the policy.
Effectiveness – Policy takes time to work.
Evaluation and adjustment—Did the policy work? Have conditions changed?

23. A Matter of Timing Example—Kennedy Tax Cut
Discussed in 1961; Proposed in 1962; Enacted in 1964.
Lowered marginal rates from 91% to 70% at the top and from 20% to 14% at the bottom.
Rates in between were cut by about 30%.
Results:
Had little effect on the economy until
Long-term effect on economic growth was significant.

24. A Matter of Timing Example—Bush Tax Cuts
Marginal rates were cut in 2001, 2002, and 2003.
Each cut was less than 1% of GDP
The economy was already recovering.
Most went to relatively high income groups who save a larger fraction of their income.
Low income people pay little income tax.
Result:
Little effect on AD.
Instructor Note:
The Bush Tax cuts were enacted in 2001 and 2003 they are scheduled to expire on January 1, 2011.
Because the expiration of the tax cuts was known from the beginning, what effect would this have on their effectiveness?
As we approach the expiration date what effect will this have on household and business spending?

25. A Matter of Timing Monetary policy is also subject to lags, but…
Generally are shorter than for fiscal policy.
Federal Reserve can act very quickly.
e.g. After 9/11, the next day the Fed stepped in with massive infusions of cash to the banking system.
Only advantage of fiscal policy is that the effectiveness lag is shorter.
Monetary policy depends on willingness of banks to lend and businesses to borrow.

26. A Matter of Timing
Automatic Stabilizers—changes in fiscal policy that stimulate AD in a recession w/o explicit action by policy makers.
Welfare and transfer programs
In a recession more people apply for welfare assistance and unemployment benefits → ↑ income →
Consumption smoothing
People drawing on savings during an economic downturn.
Credit cards can help consumption smoothing

27. Government Spending Versus Tax Cuts As Expansionary Fiscal Policy
Political differences
Tax cut—puts more money into the private sector, Bush (Republican) favored tax cuts.
Spending—grows government, Obama (Democrat) focused on spending.
Economic differences
Government spending is spending by definition.
Tax cuts will increase spending only if people spend and don’t save their new money.

28. Fiscal Policy Does Not Work Well to Combat Real Shocks
Real shocks reduce the productivity of labor and capital
Solow growth curve shifts to the left.
Government responds by increasing .
Because the economy is at full employment most of the increase in will crowd out private spending.
Most of the effect shows up as ↑P.
Let’s use our model to show how this works.

29. Effect of a Real Shock Inflation rate (p) c 16% b 8% a Real GDP
Solow growth curve shifts left:
↑p → SRAS shifts up
↓ real growth rate → recession: a → b
Old
Solow
growth
curve
New Solow
growth curve c
16%
→ ↑AD
Result:
Even higher p ;
Slightly higher growth: b → c
Old SRAS b 8%
New SRAS
Instructor Note: This diagram excludes the effect of crowding out.
The economy starts out at a with a growth rate of 3% and a low rate of inflation at point a.
The real shock is shown as a shift to the right of the Solow growth Curve
The real shock results in a higher rate of inflation so SRAS shifts up to adjust to the higher rate of inflation.
The economy moves from a to b.
Result: A much higher rate of inflation and slower economic growth; in this case the growth rate is negative so the economy is in a recession.
An increase in government spending can increase AD. However, because at point b the economy is on the Solow growth curve, the ability to increase real GDP is limited.
Result: Even higher inflation; slightly higher real growth rate but the economy is still in a recession.
Conclusion: Fiscal policy stimulus other than increasing the rate of inflation has little effect.
(1)
Real
shock 2% a
Real GDP
growth rate
-3%
-1% 3%

30. Check Yourself
What happened to make the 2008 Bush tax rebate less powerful than anticipated?
Explain why a permanent cut in income tax rates can create a larger fiscal stimulus than a temporary cut?
Keeping your answer to the previous question in mind, why does a permanent investment tax credit create a smaller fiscal stimulus than a temporary investment tax credit?

31. When Fiscal Policy Might Make Matters Worse
If expansionary fiscal policy is paid for by borrowing…
Taxes will rise in the future.
Higher future taxes will contract the economy.
Ideal fiscal policy will increase AD in bad times and pay off the debt in good times.
Governments usually operate like this…
Increase spending in bad times.
Increase spending in good times.
Result: Rising debt

32. When Fiscal Policy Might Make Matters Worse
Interest payments on the debt can become a large fraction of the budget.
Excessive government borrowing can lead to economic collapse.
Example: Argentina
Government debt rose to 150% of GDP.
The country defaulted on its debt—the largest default by a government in the history of the world.
Savings flowed out of the country to Miami and other places.

33. When Is Fiscal Policy a Good Idea?
When dealing with an emergency
War, Worsening depression, Natural disaster
When crowding out is less likely.
Fiscal policy is most likely to matter when:
When the economy needs a short-run boost, even at the expense of the long-run.
When the problem is a demand shock not a real shock.
When many resources are unemployed.

34. Takeaway Fiscal policy is most effective…
In times of emergency
When there unemployed resources
When the economy needs a short-term boost.
Fiscal policy is not good at boosting long-term growth.
Fiscal policy sometimes doesn’t work…
Because of “crowding out”.
When people cut spending in fear of higher future taxes—Ricardian Equivalence.

35. Takeaway
Most changes in government spending are not big enough to make much of a difference.
Automatic stabilizers help stabilize AD.
Some countries take fiscal policy too far.
Accumulate large amounts of debt
This can destabilize finances, currencies, and sometimes even governments.
Good fiscal policy may not do a lot of good
Bad fiscal policy can do a great deal of harm.

36. End of Chapter 18